Ongoing Execution and Knowledge Acquisition

Is working harder or more necessarily better?

It’s been about 5 months since I started on this options path, internalized options theory via all forms of media (podcasts, youTube videos, blog posts, news articles, academic articles, forums, StockTwits/Twitter, writing in this blog, etc.), and applied the principles in end-to-end practical trading matters, and now have under my belt the execution of hundreds of trades.

Much of the middle three months of those last five months was dedicated to writing a 4,000-line Python program to connect with the Interactive Brokers API.

The past month or so was when I found out about VIX, internalized the main ideas by a few books, dozens of podcasts/videos, and dozens of articles. I’ve started unwinding the rest of my options positions to focus exclusively on shorting options on $VIX-derived ETPs, especially $VXX. All this is detailed in the most recent couple blog posts.

Now that my focus has shifted to $VIX, unfortunately much of my work in writing the Python program simply isn’t needed anymore. There were many moving parts in filtering candidate underlying stock, ETFs. and options chains, constant scanning for high implied volatility setups, ingesting and managing the tick data, formulating trade entry/management/exit, and a few other components such as determining earnings dates that simply are no longer needed with this new focus on $VIX.

Fortunately, I gained a lot of excellent knowledge in practical coding/data/trading matters when it comes to writing a comprehensive trading program, and furthermore, know that I don’t need to write another anticipated 20,000 lines, at least, to do all the things I wanted to automate away. I’ll still be using parts of the program such as, for example, automated trade execution for large blocks of options since IB only permits 5 contracts at a time. To give a sense of how that 5-contract limit fits into my trading, I have close to 200 total options contracts in 100 spreads currently outstanding on $VXX call spreads alone. Also, tasks like scanning all SP500 companies’ underlying volume, option chains, and earnings dates for earnings trades can still be used as a short-term options strategy.

Up until now, I’ve been in an ongoing highly active state of knowledge acquisition and doing, mostly writing the trading program and entering/existing trades. I’ve done so many trades that I earned a reward of a premium subscription service from Interactive Brokers. Reminds me of when I played so many hands 12-tabling Texas Hold’em @ 600 hands/hour on PartyPoker, that I won a laptop for being in the top 10 in flopping sets across their worldwide network in 2006.

I’m finding I’m constantly questioning myself though: What additional value would working and researching harder and more frantically do now relative to just focusing on execution of this defined plan, while accumulating longer term big picture knowledge? Execution on the plan entails trading on a single trading thesis: short call spreads spreads on $VXX since it is decaying. I don’t think there’s much more value to be added simply by being more active, so I’m piloting a plan for the next month to just relax and just give my trades time work out. When they do hit the profit targets, simply execute more short call spreads on $VXX without too much analysis or worrying for now, and wait until another  2-3 months to worry about a much deeper assessment and refinements to the overall strategy.

As an example of what more I wanted to do, I had a much more detailed blog post in mind concerning a very strong inverse correlation between the $DXY (dollar index) and $SPY (US domestic equities index), and how those trading equity indexes are actually unwitting currency traders.

Another blog post idea concerned given an expectation value of the sum of payoffs multiplied by probabilities, the human mind actually prefers a lower expectation if it’s accompanied by higher probability (and frequency) of winning with smaller individual payoffs relative to a higher expectation accompanied by lower probability (and frequency) of winning with higher individual payoffs, and the implications of this for portfolio growth with respect to the theory in the Kelly Criterion. (I suppose I just wrote most of that in this single paragraph.)

In general, this entire strategy has 4 distinct areas where I can allocate my time towards improving.
1. Options theory (Greeks, implied volatility, spreads, etc.)
2. VIX (futures term structure, ETN characteristics, dependence on macroeconomy, etc.)
3. Trading mechanics (Risk and position-sizing, profit targets and optimal recycling of capital, commissions/fees, etc.)
4. Psychology (Maintaining a healthy life overall, making correct trading decisions despite feeling emotions, how trading is a means to a good life instead of life itself, etc.)

Ultimately, trading $VIX is trading macroeconomics in the form of Central Bank policy, geopolitics, macroeconomic indicators, broad market indexes, general sentiment, etc., so I plan to focus my attention on knowledge acquisition in macroeconomics relative to other parts of trading prep/work for now due to its absolute importance, but also do to its relative lack of development in my overall strategy. This will be where my attention to for the next month or so.

I’ll leave it with something I wrote.

—

Hello darkness, my old friend
I’ve come to long $TVIX again
Because Jim Cramer’s crazy creeping
Left its seeds while I was sleeping
And the long $TVIX trade that was planted in my brain
Still remains, and does not seem, to silence

In chaotic charts I watched alone
Narrow spikes of bright red tone
‘Neath the halo of CNBC
I turned to my broker’s trade entry
When my eyes were stabbed by the flash of green neon light
That reached great heights
And broke through, resistance

Then came the naked shorts I saw
10,000 $TVIX shares, maybe more
People twitting without speaking
People liking without reading
People posting insults that voices never shared
And no one dared
Question the trade of Long $TVIX

Fools, said I, you do not know!
Losses in long $TVIX will grow!
Hear Seth’s words that he might reach you
Short $TVIX that he might teach you
And $TVIX price like silent raindrops fell
And continued down, in silence

So people who went long $TVIX, they prayed
To Cramer, “rigged” gods they made
And VIXCentral flashed out its warning
In the Contango that was forming
$VIX term structure said the words of the profits are written in The Fed halls,
And Stock Twit walls
And whispered in screams, Long $TVIX

Short Call Spreads vs. Long Put Spreads in Long VIX-derived ETPs

This blog post consolidates a series of forum posts I wrote to better understand and formulate an optimal options trading strategy on long VIX-derived ETPs (exchanged-traded products) such as $VXX and $UVXY that will spike upwards violently in brief spurts and decay downwards most of the time.

(Through this post, options spreads are considered since that’s what I’m trading due to their risk-defined nature and for slightly better comparability. The ideas and consequences would still apply to naked option positions, short vs. long, calls vs. spreads, but only imperfectly so due to the asymmetric payoffs and tendencies of the underlying to decay. It would be the subject of another technical post to get to those nuances.)

A. Implied Volatility Rank

Implied volatility rank (IV rank) appears to be the core determining factor.

High IV Rank
If there’s been market activity that causes IV rank to quickly rise, such as a quick up spike, IV rank will be high and it favors shorting bear call spreads as options are now overpriced and will become cheaper quickly as IV rank reverts to the median 50th percentile. One example would be Brexit.

Low IV Rank
If IV rank is low due to low volatility of $VXX or $UVXY and calm markets and/or a steep contango curve, it might be better to go long puts since options are relatively low-priced since iv rank is most likely low.

B. Theta Decay

An important rationale for options positions is Theta time decay. It work sfor you when short calls or call spreads, and works against you when long puts or put spreads.

When applied to to VIX-products like $VXX and $UVXY especially, it seems like even though options Theta decay is important for both net long and net short options positions, the more important issue simply having enough time to wait it out for the decay of the underlying VIX-derived ETPs themselves, which we know is an expression of the VIX futures term structure and ultimately of the nature of volatility and human psychology itself .I like the longer duration since it gives you a lot of time for the “underlying” to decay.

In other words, even though the usual Theta time decay factor of options still applies for better or worse dependent on a net short/long position, the more important issue is giving oneself more time for the underlying to move in the direction we know it will move.

C. Two Questions

So I’d like to pose it in terms of two questions:

1. How would this put spread strategy compare with shorting call credit spreads on high implied volatility (IV) spikes?

The relevant event to cause a high IV spike here would be an up spike of the “underlying”. If you enter a call credit spread, you win in 3 ways: higher short options premium due to higher IV, decay of short options premium, and expected natural downward movement of underlying (assumed to be long vol such as $VXX or $UVXY).

2. Could a mixture of the following Bearish spreads be even better still:
(a) short credit call spreads and (b) long debit put spreads?

Debit spreads in general are better in low IV scenarios trending into a higher IV. The example here would be if the “underlying” ($VXX, $UVXY) were trending downwards in calm markets without any recent up spikes.

If there were an increase in IV of $VXX/$UVXY options, then it could be from a sudden movement of the underlying, either upwards or downwards. It seems an up spike like this is more likely in calm markets due to the nature of these instruments.

The other scenario of increasing IV and yet fast downward move would be if the were calm followed by a sharp rise in contango. It seems this scenario is much less likely.

D. Takeaway

So my takeaway is that it might be better to short credit call spreads since long debit put spreads work best in low IV environment (calm markets) that’s transitioning to a high IV environment, which is more likely to be for an up spike in the underlying which would move against both credit call spreads and debit bear spreads, rather than a down spike that would move with both call and put spread positions as well.

In other words, you need both low to high IV and the underlying position to go with you for optimal bear debit put spreads. In the call credit spread in contrast, you may benefit in all environments, especially high IV ones, and you don’t need the underlying to go in the desired downward direction nearly as much, and furthermore, it can even go against you a bit.

Where am I wrong in my thinking? What are the limitations even if I am right?

Side thought

It’s just wild thinking through the levels of abstraction here: (1) Complex spreads on (2) options based on (3) ETFS ($VXX and $UVXY primarily) based on (4) front two-month rolled futures on (5) the VIX volatility index that tracks an (6) options chain based on (7) the S&P500 index of (8) common stock that denotes (9) ownership in a corporation that (10) moves money that is (11) printed by the Federal Reserve and represents (12) a social construct claim check on society’s economic resources.

Trade Details: Bearish $VXX Options Spreads

Had an extremely successful January that returned 17% on invested capital on my bread-and-butter options selling strategy involving scanning for high-implied volatility rank spreads. On an annualized basis, this is a return of over 200%. However, I ask myself how I can do even better? How can I get better returns, with less risk, with less effort, and with more room for error? It’s in that vein that I’m shifting my focus since I strongly believe I can do even better.

With my recent research into VIX-derived products, I believe there’s even greater opportunity than what I’m doing now by taking a Bearish orientation on VIX via options on VIX-derived ETPs, which are the class of exchange traded products comprising ETFs (exchange-traded funds) and ETNs (exchanged-traded notes). Selling options on these VIX-derived ETPs will allows for greater leverage (each options contract controls 100 shares of underlying), precisely defined risk (no naked positions, all spreads), and higher risk-adjusted returns (a bit decreased return for effectively infinitely reduced risk since I won’t be blowing up my trading account with a huge overnight VIX upspike that may cause me to lose even more than my account value(!), since I can just wait it out for natural decay of options and VIX ETPs).

Downward-sloping $VXX graph in top part of black graph shows the trailing year price of $VXX, an exchange-traded note tracking the VIX index via rolling VIX futures for an average 30 days out. This slope has been the trend since the $VIX’s inception, this is just 5 years worth.

$VXX 5 year chart

$VXX is based on the VIX futures term structure shown in the graph below, selling the front month future “M1” in the VIX futures curve and buys the second month “M2” to keep an average term of approximately 30 days out. Upward slope is called contango and has historically existed 85% of the time. (My interpretation is that traders are expecting a more uncertain and volatile future and expect a higher price.) Since the fund is selling low and buying high across the futures term structure most of the time when the futures term structure is in contango, the price of the $VXX will be decreasing, as reflected in the black graph.

VIX futures term structure near midnight January 31st

It gets even better, much better.

The bottom of this 1 year $VXX graph is the option implied volatility (purple) vs. historical volatility (blue). The edge in selling options is the space between them.

$VXX 1 year graph

In effect, selling options spreads benefit due to the expected downward movement of $VXX (delta), time decay (theta) of the short options spreads, and the gap between implied volatility and realized volatility, which may also be a bonus if implied volatility rank is high and it reverts to its 50th percentile median value in time. Furthermore, risk-defined spreads don’t suffer from the ever-present Black Swan blowup factor while holding a naked shorting of $VXX itself and seeing it spike massively upwards during times of volatility. (As a side note, this is the main rationale of why people may go long VIX-derived products, as a hedge and potentially a Black Swan insurance) Because the spreads are risk-defined, you can put more of your capital to use more towards 70% or even 80%. In contrast, short sellers probably only want at most 20% of their capital allocated to the trade to account for quick upward spikes and rapidly increasing margin requirements.

My strategy now is to sell Bearish options spreads on $VXX. I need to do a bit of research as to which ones, but bear credit call spreads are my primary candidate, followed by Bear debit put spreads. Today I eased into 15 bear credit call spreads contracts: $VXX June 30/35 for a $1,980 credit requiring $7,500 margin collateral, and am already up as $VXX dropped from a bit above $30 to $29.50 after-hours. This is just a feeler position. Will be moving more of my capital into this trade as I unwind a large number of other trades.

15x $VXX June 30/35 for a $1,980 credit spread

Additionally, I plan to enter earnings trades opportunistically, selling straddles and strangles, and their respective risk-defined cousins iron butterflies and iron condors, on high implied volatility setups. Future posts will dive deeper into the earnings trades, which benefit from being of short time horizon of only a few days.