Making Volatility Pay

This week could see several catalysts for a volatility trade including FOMC and potentially an announcement about the trade tariffs. Volatility could certainly spike higher if there is a negative surprise or it could drift lower if those news events are considered market friendly. Of course, it could also be unchanged by the end of week. So there you go, volatility could go up, down or sideways. I hope this has been helpful, good luck this week! What? Not helpful? Well how about we look at a couple of positions which could be profitable within a range of all 3 of those outcomes.

VXX is the volatility ETN. I often use it to trade volatility. What kind of position allows for a ‘range’ trade? There are several choices but, in this instance, I am going to focus today’s post on the Diagonal spread. Diagonals, like Calendar spreads, are time spreads where the position is short an option in one expiry and long an option in a different expiry. Here is the exact position I am considering:

Notice in the risk profile above that I show how much the Jan10 VXX 17 Call would cost if I just bot that outright instead of as part of the spread. If the price of VXX is at or below 17.50 at Friday’s close, the Dec13 17.50 Call will expire worthless and I will still own the Jan10 17 Call but I will have paid just $.94 for it (net down cost) as opposed to $1.30. That is almost a 30% discount. I will then have the ability to sell other Calls against it over the next few weeks to further reduce the cost if I want to.

Below is the profit zone of the Diagonal spread shown on the daily chart of VXX to help visualize the profit range in context of the recent price action.

What if you look at that chart and think that you would like to extend the profit area further down so that, even if VXX takes out the low of 11/27, the position will still be profitable? Below shows the risk profile of the Jan10/Dec13 VXX 16.50/17 Diagonal spread. With this spread the break even prices are around 16.09 and 18.61. You can adjust the strikes to fit the scenario you think is most likely.

Whether your objective is to buy some Jan10 VXX Calls at a (net down) discount for some potential year end volatility or you are just looking for a relatively high probability trade that you would likely exit at the end of the week, the Diagonal spread is a good trade structure to consider.

That is all I have for you now. If you are not a subscriber and you would like access to the Options for Income subscriber chat room, you can sign up for a 14 day Free Trial to try out the service. What have you got to lose, it’s free!

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Paul Frey is a 30+ year trader with experience in equities, options, and futures. In addition to trading he manages Vega Options providing option educational services to new and experienced traders who are looking for improved results. He teaches strategies and techniques that reduce or even eliminate the initial cost of a trade while still maintaining potential future profits.

08th Dec 2019

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