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Inefficient ETF and Option Vertical Spreads (1/2)

8 Feb 2018,

In previous parts of this series, we have explained some basic strategies and approaches to shortening inefficient ETFs / ETNs – whether it was a short or option strategy short call or long put strategy. We have explained their advantages and disadvantages. In this work, I would like to focus on my favorite strategy, which I use very often – especially for the longer time horizons – to short volatility-based ETFs and this strategy is called the option vertical bear spread.

  • Spread = option strategy consisting of multiple options
  • Vertical = Both options have the same expiration date
  • Bear = speculation on decline. Options allow spread speculation on the decline of the underlying market through both bear put spreads and bear call spreads.

In today’s article I will focus on bear call spreads.

How does the spread works?

The whole strategy consists from 2 options – sold call option and bought call option. A sold option has a lower strike than the bought one, so we get a higher option premium than we spent on the bought call option. However, the bought option plays a very important role – it is intended to protect our sold option from potentially unlimited loss.

So, when we enter to the trade, we get a premium at the beginning (as with the short call strategy mentioned before, but with the difference that here our position is covered).

We will select the ETF as the underlying market, namely: UVXY, which has weakened by more than 90% last year. The current increased volatility is ideal for entry. To clarify the current state of the market, please see the picture below.

Vývoj UVXY 7/2017-2/2018 (zdroj: TD Ameritrade)

Figure 1: Development of UVXY 7 / 2017-2 / 2018 (source: TD Ameritrade)

As an example, we take a vertical bear call spread on the UVXY instrument with the expiration JAN19 (almost one-year horizon) and strikes 4 (sold call option) and 9 (bought call option). The blue line in the chart shows value 4, this indicates the price that must be achieved to make a full profit from the UVXY with expiration January 2019. However, it is not necessary to realize a partial profit.

Call option sell

I have already described this strategy as a particular method for shorting the market. So, you already know its diagram. If I would short a call option with strike 4, I would get actually 16.91 or 1691 USD per contract. That’s a lot of money, but taking into the account the potential for extreme growth (see Monday’s growth of UVXY by more than 50%, and we are not mentioning post-market growth), then even this “fat” premium may not be enough to cover potentially unlimited losses.

Opční strategie short call (strike 4, JAN19) (zdroj: TD Ameritrade)

Figure 2: Short Call Option Strategy (strike 4, JAN19) (Source: TD Ameritrade)


Buying call option with higher strike

To limit the potential loss, we buy a call option (strike 9), for which we will pay 14.81 or 1481 USD per contract.

The option diagram of the bought call option looks like this:

Opční strategie long call (strike 9, JAN19) (zdroj: TD Ameritrade)

Figure 3: Long call option strategy (strike 9, JAN19) (source: TD Ameritrade)


Summary – both options together

If both positions are put together, we get the desired vertical bear call spread, which has following parameters:

  • Expiration: JAN2019
  • Spread:  4 – 9  call option
  • Max profit: Difference between the premium for sold (+) and bought (-) option = 16.91 – 14.81 = 2.10 = 210 USD per contract. This full profit is realized if, at the expiration (ie January 2019), the UVXY price is below 4.
  • Max risk: Strike price difference between the two options (5 points = $ 500) minus the premium received (2.1 = $ 210) = $ 290 / contract. We will sustain this loss if the UVXY price will be above 9, when it expires in January 2019.
Diagram opční strategie bear call spread 4-9 call JAN19 (zdroj: TD Ameritrade)

Figure 4: Option bear call spread strategy diagram 4-9 call JAN19 (source: TD Ameritrade)

The basic rules of the bear call spread trading


Again, the conclusions already mentioned in the previous chapters are valid, ie we want to ideally enter at higher prices of the underlying market to get a better premium for given spread. As I mentioned earlier, I use my own calculation model for these purposes, which includes the achievable premium (for a particular option structure, VIX position, time to option expiration, etc.).



Typically, at 80-90% of the premium received

Time Stop-loss – up to 3 months before the expiration date (applies to trades that are open for at least 8 months, of course, it does not count for shorter – purely speculative short-term trade).

If the underlying asset goes further against my position – i.e. grows – there is no reason for panic, max loss is ensured. When it comes to the strike of sold call option, I only follow the time value, which should not be zero, resp. close to zero. Then there is a risk of the assignment for the sold call option, ie instead of 1 option sold, I will have 100 pcs of the underlying asset in a short position. While this is not a problem, as the position is still protected by the bought call option, the problem may appear with a high cost for short position – borrowing fee (up to tens of% of the nominal short position). Therefore, if this happened (typically if the underlying market is very high), I close the whole position and consider entering at higher strike. In any case, I will deal with the issue of assignment in some of the other chapters of this series.

Little Recap


  • Strategies with a clearly defined risk profile, predefined loss and profit
  • Since the position is secured, there is no need to close the position if the price of the underlying asset goes against the position in the unfavorable (often very short-term) movement


  • Limited profit potential
  • In the case of bear call spreads, the risk of assignment of the sold option at a high level of the underlying market

A few words at the end:

Monday’s trading clearly showed how the strategy of buying inefficient ETFs / ETNs in volatility can be tricky … Even though instruments such as XIV or SVXY recorded a huge devaluation in the past years, one day was enough and it can be said that everything is over. XIV was erased from the surface of the earth – better say from the stock market, trading on SVXY was eventually restored after huge losses. However, the result is poor – see the chart below. While on Friday 2.2. the price was above the value of 100, the current state (Tuesday 6.2.) is at the level of about 12. The decline on Monday by more than 80% (including after-market) in a single day tells everything.

Graf SVXY 2017-2018 (zdroj: TD Ameritrade)

Figure 5: Graph SVXY 2017-2018 (source: TD Ameritrade)

Both instruments have one thing in common – the great inefficiency created by “tracking-error” (or if you want the compounding effect). Therefore, despite a very interesting appreciation in recent years (which was accompanied by extremely low volatility), I have always warned investors not to purchase these instruments, but on contrary, I have seen shorting SVXY through vertical bear call spreads as an interesting hedge strategy to spread option positions to bear call spreads on UVXY (see example above) in my portfolio. Many thought it was a non-sense strategy at first glance, but the development in recent days has fully confirmed this thesis and very interesting profits on these bear call spreads at SVXY have been realized. I will discuss this more in one of the other chapters that will be dealing with the combination of option positions on such ETF / ETNs, which are mutually opposite to each other.

I hope you are doing well in these volatile days!


Note: The problem of unsecured positions hit also several hedge funds, who were not expecting volatility change in the market and they did not secure their positions.

I really recommend to read the following article and remember how the whole thing may also finish:



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