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.