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Inefficient ETFs and long put option strategy

1 Feb 2018,

In previous parts of this series, I have explained the basics of ETF short strategy and naked short call strategy. With both strategies, we can benefit from the decline of the underlying ETF to gain an interesting profit, but – as we have seen – with the thread of the theoretically unlimited loss. It is always necessary to have a plan B – what to do if the market situation does not develop according to our ideas.

In today’s work, I will introduce one of the basic option strategies, and it is the strategy of buying put option – also known as a long put. I have already explained that options as such are characterized by asymmetric rights (for buyers) and obligations (for sellers). For the right (either to buy or sell), the buyer pays to the seller an option premium that represents the maximum possible loss from the transaction. On the other hand, a seller will receive this premium in exchange for the obligation to a counterparty – to sell or buy a certain amount of the underlying asset. The relationship is therefore asymmetric.

But enough of option theory.

The long put option strategy simply entitles you as a buyer to sell (or speculate on decline) a certain amount of underlying asset within a specified time – till the expiration date of the option. As a buyer you pay a certain amount of money (premium) and that’s your maximum possible loss from the entire transaction.

Let’s explain everything on the example of VXX.

Development in recent months is following:

 

Vývoj instrumentu VXX (2017-doposud) (zdroj: TD Ameritrade)

Figure 1: Development of the VXX instrument (2017-so far) (source: TD Ameritrade)

 

Let’s say that you want to speculate on a further drop in its price (it is a model example, with the current low volatility I am still waiting for the right entry possibility – we will talk about the timing of the entry in the next chapters).

For example, we will choose the timeframe with expiration JAN19 (ie January 2019) so that all the inefficiencies (which have already been discussed in the previous chapters) can be fully reflected, and the market will have enough time and space for further decline.

 

Opce VXX: JAN2019 (zdroj: TD Ameritrade)

Figure 2: Option VXX: JAN2019 (source: TD Ameritrade)

 

We choose, for example, a put option with strike 25 and with a premium of 6.70 (Ask price), so we pay 670 USD for 1 contract, which represents our expenses and the maximum possible loss from this transaction.

The break-even point is thus at the strike minus premium level, that means 25 – 6.70 = 18.30. Though it seems to be a distant level from today’s point of view, let’s repeat that VXX has weakened by more than 70% in the past year.

 

Diagram zisku/ztráty nakoupené put opce, strike 25, expirace JAN19 (zdroj: TD Ameritrade)

Figure 3: Profit / loss diagram of the bought put option, strike 25, expiration of JAN19 (source: TD Ameritrade)

What are the possible scenarios (expiration – blue curve):

  • The cost of the underlying asset gets below B/E (break-even) (ie below 18.30). Then we have a profit from the position – and we are practically limited only by zero, for example if the price at expiration is 15, then the price of the option will be 10 (difference between the strike 25 and the prices 15 = 10), but the cost was 6.7, – 6.7 = 3.3 (330 USD / contract)
  • The price will remain above the B/E, but lower than the strike (25) – for example, if the price is 20, then the option will be 5, but we have spent 6.7, so we are still in loss 1.7 (170 USD) per contract.
  • The price remains above the option margin – then we lost the full premium (loss of 670 USD / contract)

 

I would like to point out that those are option expiration scenarios. However, in the course of its “life”, the price of an option changes due to many parameters – market price movements (the lower, the better), the expiration time (the closer is the expiration, the worse) or the volatility (higher volatility of the underlying market increases the option price). So, it is possible (and it is absolutely standard) not to wait until the option expiration and go for an interesting profit while closing the position during its lifetime. The current daily profit is shown by the purple curve on the diagram (in the ThinkOrSwim platform it is possible to model its dependence with respect to the movement of the underlying asset, volatility, expiration time), this bring us better overview about when and under what conditions can I, for example, earn 20-30% from the invested premium, etc

 

What are the basic approaches for trading long put for the volatile ETF?

  • Entry for a low premium, ie we want ideally the increase of the underlying asset price to get lower cost entry (eg  VIX> 20 condition, this is important to be set within the trading system, I will describe it in the following chapters)
  • The selection of the expiration month of the option depends largely on the volatility value (measured by the amount of VIXU or by contango / backwardation on the nearest VIX futures contracts) and, of course, based on the trading style (whether trader prefers more aggressive types of trades or more conservative approach):
  1. Higher volatility (or even the market in backwardation)> More aggressive expiration for several weeks – units of months (assuming the return of volatility to the “normal” over the weeks horizon and “help” of contango)
  2. Low volatility (contango market)> better to choose a longer expiration (6-18 months), it is not possible to expect too much help from the decline of the volatility base, but merely the contango effect, which is very high at such situations (even over 10% per month)

 

  •  Position management:Entry ideally at a higher level of the underlying asset (volatility spike on VIX or VIX futures in backwardation, possibly more conservative – return of the market from backwardation to contango)Exit:
  • with 30-40% of the option price (this is very individual, it also depends on the number of contracts, when part of them can be left longer in the market, etc.)
  • On the basis of the remaining time to expiration – we do not want to risk growth against the position in the last months before the expiration, so for long-term positions (with expiration> 1 year) that are benefiting from the long-term inefficiency, we close the trade at least 3 months before the expiration.When the price of the underlying asset is moving against us:
  • Exit after 50% loss of the premium, respectively. To roll debit into the more distant expirations (a bet for long-term reassurance of the situation)
  • Possibility of a regular selling of short-term put options (weekly – monthly, strike prices to be chosen according to the average contango) against the long-term position, which will allow partial coverage in the case of the growth of the underlying asset

     Little recapitulation

    Advantages:

  • An interesting yield potential
  • Clearly given maximum loss = paid premium
  • No additional costs for shorting (borrowing-fee)Disadvantages:
  • Usually high initial cost for the option purchased
  • Rather a psychological disadvantage – to make a trade profitable, something must happen (the price must go down, vs. the OTM call option sell) during the life of the option

     Conclusion:

    While it might not seem to be the case at first glance, such a simple option strategy is also widely used among funds to speculate on the fall of the underlying market – in our case, ETF linked to volatility. The advantage is limited cost, ie limited maximum loss and no fees associated with underlying asset shortening. For someone, a (rather psychological) disadvantage may be the need of the substrate movement within a defined time frame in order to make a profit.

    In the next work we will look at the option combinations and I will explain the basics of spread strategies.

 

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