SmoothSailing#12

(This blog is now obsolete, as VXX has been “delisted” by Barclays. However there are other inverse etns out there such as UVIX that would work with this method. -January 2021)

Ok this goes against my normal preaching, (always selling, never buying options) but now that you are a salty and well-experienced option trader, you might want to take a look at the next level. I’m now going to talk about buying options instead of selling them. I’m still selling them as my main income stream, but when I have some extra cash and the situation is right, I buy.

Some background. VXX is the security I use when I buy options. VXX is an ETN, not an ETF like IWM or SPY. Exchange-traded notes (ETNs) are types of unsecured debt securities that track an underlying index of securities and trade on a major exchange like a stock. ETNs are similar to bonds but do not have interest payments. Instead, the prices of ETNs fluctuate like stocks. They are tradeable and some have options.

VXX, the Barclays iPath Series B S&P 500 VIX Short Term Futures ETN, tracks VIX. VIX is the ticker symbol and the name for the Chicago Board Options Exchange’s Volatility Index, a measure of the stock market’s expectation of volatility based on S&P 500 index options. You can’t trade VIX directly, so I use VXX.

Do I care about all that? Nah. Just know VXX is a high-volume high-volatility ticker for trading short-term options.

VXX, since it tracks expected volatility, usually sees explosive moves when the S&P 500 declines. The moves in VXX typically far exceed the movement seen in the S&P 500. For example, a 5% drop in the S&P 500 may result in a 15% – 20% gain in VXX. That means when the stock market drops 900 points in one day, VXX goes through the roof.

VXX also has backwardation after a spike. That’s a fancy stock market term which means the financial instrument in question is expected or designed to go down over time. When market volatility increases dramatically during a correction, it is expected that it will return to normal in the future. That’s backwardation. That means that it is expected that VXX will go back down once the correction is over. And this is, indeed, precisely what happens.

So what does all this mean? It means that when the market tanks, VXX shoots up. At that point I buy to open puts on VXX at or near the money. When VXX inevitably retreats, those puts then go far into the money and are now worth more than I paid for them.

When I buy these puts I buy them out about four months. That gives me three months for the market to recover, which statistically is almost always does, before the time value begins to erode on me. And all I need is one good day, one of those days when the market pops up 600 points. In three months, you know that’s going to happen sometime. That pushes my puts into the money far enough that I can sell to close at a nice profit.

This last go-round of market volatility was a good example of how this works. Starting Friday, November 26^th, the market dropped, bounced back Monday, dropped again Tuesday and then recovered once again on Wednesday.

I bought puts on VXX on Friday at the money, sold them for 12.6% gain on Monday, bought them again on Tuesday and sold them this morning, Wednesday December 1^st, for another 14.2% gain.

I’ve made my weekly goal just with VXX this week, not even counting my normal IWM calls and puts that I have out. This doesn’t happen all the time, but it does happen three or four times a year.

Check out this chart.

You’ll see my fancy green arrows, one at each date when the market took a hit. Each time VXX spiked, then recovered, usually pretty quickly. I bought puts on each of these and sold them within a day or two at a minimum of 10%. gain. 10% is my goal, and if you wanted to hold these a few weeks longer, you could probably hit 20% with some regularity, but I figure 10% in one week or less is PDG. (New SmoothSailing technical nomenclature: PDG is Pretty Damn Good.)

This would not work as well on anything but VXX, since it has to go down once we buy the options. You can guess market direction all you like with stocks, technical indicators and market news but VXX is based on volatility. It over-reacts when we have a correction and, unless an asteroid strike or the zombie apocalypse occurs, volatility is going to go back down. Since either of those would negate any stock market holdings we might have anyway, it seems like a good trade to me.

You will need to sell these to get out with a profit, so it does take some action. You have to sell to close when you are happy with your gains. If for some reason things go against you, you will want to sell and get out before you take too much of a hit. Maybe set an eight percent loss strategy and get out then. Don’t buy VXX puts except when the market is correcting and VXX is spiking. You have to be sitting at your computer to place the order as you watch the market, a few hours can mean the difference between a good trade and a sketchy one. I actually buy at several different strikes to ride the climb if needed. Friday, for example, I bought puts at the $23 strike, then a little later in the day, as VXX kept going up and the market kept going down, I bought $24 and then $25 strikes. I think it finally hit $29 but I was out of money. You just don’t know how high it’s going to go. You also don’t know how low it will go, so set your profit level and be happy with that. Waiting too long can be a mistake.

I’ve had good luck with this for several years, and only had to get out at a loss when I got too greedy. In fact, this week, I had some DIS that was way underwater. I sold it Friday, used those funds to do all this VXX put buying, made that 26.8% gain in a few days, and now I’m back in cash and so bought the DIS right back.

So there you have it, another tool for your toolbox.

Any questions just ask!