Market volatility has dropped slightly in recent weeks as measured by the CBOE Volatility (VIX) Index. VIX is a real-time index that represents the market expectation for near-term volatility in the S&P500 index.
Investors and traders have long used VIX as a measure of the level of risk, fear or stress in the market.
The iPath S&P 500 VIX Short-Term Futures ETN (VXX) is a volatility exchange traded note (ETF) and behaves differently to a regular ETF. VXX typically sees large price increase when the S&P500 tanks. However, most of the time it slowly but surely drops in price. Take a look at a long-term chart and you’ll see what I mean.
Buying VXX Call Options To Protect Against A Volatility Spike
Some traders will buy VXX call options as a method of protecting against rising volatility. Let’s look at a couple of different examples.
A long call option trade gives the buyer of the option the right to purchase a certain stock at a certain price (strike price) up until a certain date (expiration date).
Suppose an investor is worried about a market drop and associated volatility spike between now and mid-August.
The investor could purchase a VXX August 19 call option with a strike price of 27. This call option contract was trading on Friday for around $1.10 meaning the investor would need to pay $110 to purchase the call option.
The maximum loss is limited to the premium paid, which in this case is $110. The maximum loss would occur if VXX closes below 27 on August 19. The breakeven price is 28.10 which is calculated by taking the strike price and adding the premium paid.
The maximum potential gain is unlimited.
Savvy traders can further reduce the risk by selling an out-of-the-money call, turning the trade into a bull call spread.
For example, selling the August 19, 32 call would reduce the trade cost by around $50 but would also limit the upside above 32.
Conclusion
Using VXX options can be simple and cheap way to buy some protection against a sharp selloff in stocks between now and August. The trade can be placed relatively cheaply at $110 for the long call or just $60 for the bull call spread.
While it is important to keep in mind that it may take a fairly large volatility spike to see VXX jump above 27, for a low cost, this particular option trade could help you sleep easier at night.
VXX and VXX options behave differently to regular ETF’s and options, so it is vital that any trader using this product fully understands the risks involved. As always, do your own research and due diligence before risking any of your hard-earned capital.
Please remember that options are risky, and investors can lose 100% of their investment. This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.