Volatility Trading: Trading The Futures Premium

By Lawrence G. McMillan

This article was originally featured in the 5/20/16 edition of The Option Strategist Newsletter.

One way to take advantage of these premiums is to establish the VXX/SPY put hedge. We have had a position on constantly for nearly two months now. These option-oriented positions aren’t making much money because $VIX is going nowhere, and so we are losing the time value. That is offset to a large degree by the “edge” that the position has in the futures premium.

Another approach is often used by professionals, although it has greater risk and greater margin requirements: rather than buying puts on both entities, instead the idea is to short both underlyings. Since one can’t short VXX easily, he would buy XIV (the inverse VXX) instead.

This approach has one serious deficiency to the option position: a huge move in the markets will always produce a profit in the option position (because the losing side has limited risk – it’s a long put). But in the “underlyings” approach, there is no cap-out on losses. For example, if $SPX should collapse in a manner similar to last August or January, the short SPY position would do very well, but since $VIX (and VXX) would be exploding, that side would suffer large losses. The tradeoff is that the “underlyings” approach has no time value risk, and hence does better if the markets remain stable or calm.

This article was originally featured in the 5/20/16 edition of The Option Strategist Newsletter. Receive the feature articles immidiately each week by subscribing now.