Building a Core Volatility Short Using UVXY Options

Several volatility trading strategies advocate using a “core” short volatility position to benefit from the drag of contango and beta slippage on these products. Holding a permanent short position in UVXY would allow a trader to benefit from the average 60-90% yearly loss these funds suffer from. However, establishing or maintaining this permanent short position may be undesirable due to short borrowing fees, margin requirements, or even impossible if the shares are unavailable either due to market conditions or choice of broker.

But just because you can't short UVXY or TVIX directly doesn't mean you need to miss out on these downward moves year after year. Consider building your core with options.

This trade involves selling short calls. The premium collected on the trade approximates how much one would earn from the average natural decay of holding the underlying ETF in that period of time. This trade has the advantage of being much less volatile than a pure UVXY short position, and in some cases allows for lesser margin requirements compared to a short with UVXY shares. For some traders, the smoother nature of gains and the steadier decay of options value can also be easier to stomach on a day to day basis. Finally, if you sell options with higher strike prices than currently trading, you have the opportunity to make a profit shorting UVXY even if its price rises.

Keep in mind though that this is still a risky strategy, and every bit as risky as holding UVXY or TVIX short. Traders interested in better risk management will have to supplement this strategy with one that helps prevent catastrophic losses in the event of a major or unexpected VIX spike. That is a topic for another discussion, but not one that should be ignored. You can lose more than your initial investment with ANY short volatility strategy!

Here's how building a core volatility short position with options works:

Identify the amount of decay expected for the time period in question. One way to start would be to find the expected loss of UVXY over the next 12 months. Looking at historical performance, UVXY has lost between 62-96% per year every year since inception in 2012. For this example, let's use a very conservative estimate of 70% loss per year, which falls between 2014 and 2015 in terms of fund performance. If you want to take a safer approach, use an even smaller number. For a more aggressive approach, use something closer to 80-90%. Keep in mind in a fierce bear market, UVXY will have substantial gains over the course of a one year period. This entire strategy is not appropriate for an extended bear market.

Identify the duration of options you wish to trade. When running this strategy, I like to use options with approximately 45 days to expiration. This usually gives the trade enough time to work, the option has enough theta on it to decay more rapidly in my favor, and the expiration date is soon enough that spreads and trading volume are becoming decent on the option chain. Monthly expirys this far out have tighter bid/ask spreads and better volume than the weeklys though, so monthly chains should be used. You may wish to go closer in expiration or later. Keep in mind each has their benefits and drawbacks.

Identify your position size. I try not to allocate more than 10-20% of my account to short volatility at any given time. Sure, I can go higher if I'm feeling particularly aggressive and the conditions are right, but at the same time, I face increasing risks of a position moving against me and wiping out my account. At least if I have no more than a 10% short vol position, UVXY could triple, and the most I'd be facing is a 20% loss in my account (assuming I had no other protections in place whatsoever). Still substantial, but not impossible to recover from. In this example, let's take 10% of my account size and allocate that to the UVXY short call trade. This should reflect the amount of UVXY that the contracts represent. It is NOT the amount I expect to receive for the option trade.

Let's say UVXY is trading for $11. Let's also assume I have a $100,000 account, and I wish to allocate 10% of it or $10,000 to this trade. The greatest number of options I could sell is 10,000/11/100=9. (Each contract represents 100 shares of UVXY, so this represents a short position of 900 shares.)

Identify the amount of premium required. Now that I know how much of a loss I expect of UVXY in a year, I need to figure out how much of that would be expected in the next 45 day period. My preferred way to do this calculation is base it on the annualized performance (if using -70% annually, we'll convert it to a fraction, 0.3 – in other words UVXY would have 0.3 x the original investment after one year if it experiences a 70% loss). Then if I decide to use 45 day options, I need to figure out how much loss would be expected in that 45 day period.

There are eight 45-day periods in a year. Remember losses are compounded. So if there are 8 periods of loss leading to 0.3 of an initial investment remaining, take the 8^th root of 0.3 ( 0.3^(1/8) ), or 0.86. This means that for every 45 days, I would expect 0.86 of an initial UVXY investment remaining, for a 14% loss.

Now that I know how much loss we expect from UVXY in a 45 day period, I identify what that loss would be dollar terms. This equals the amount of premium I need to sell to replicate the expected gains made shorting UVXY during this period of time. For this I need to know the current trading price of UVXY. If UVXY is trading at 11, multiply 0.14*11 to get the dollar amount of loss. In this case, 1.54. 

Choose the proper strike to sell. Now that I know the amount of premium to collect (1.54), I go to the the options chain and find the call selling for 1.54 in 45 days and sell that call. Currently, that happens to be the 14 Call expiring in 45 days. So I sell 9 of the 14 calls expiring in 45 days, and collect $1386 in premium (9*1.54*100). If UVXY closes below the 14 strike in 45 days, I keep all of it. And in the meantime I have a $3.00 cushion on top of the $11.00 that UVXY is currently trading at to give the trade some wiggle room.

Closing the trade. If UVXY is well below 14 close to expiration, eventually the option will be worthless or maybe worth a few pennies. Most traders will close it at this point (many brokers offer free buy-to-close option trades – use them!). This avoids gamma risk. In other words, I already collected 90-95% of the profit possible, so why have one bad news story potentially wipe out my entire profit if UVXY suddenly moves a few days before expiration? By then I would want to have a pile of cash ready to go into my next trade anyway.

If the trade is still working and UVXY is closer to 14 near expiration, there are a few options. I can roll the call to a later period to buy myself more time. This means I buy back this call and sell a more expensive call later in the future to allow more time for the trade to work. Alternatively, I can close it for either a loss or gain and leave the trade entirely. Or, I can leave the option to expiration, and if it finishes in the money, I can get assigned shares if I want to go that route (assuming it's possible with the broker) and continue to let the UVXY short shares work the trade for me beyond expiration date.

Once the options expire worthless or are closed, I am on the hunt for the next 45-day option. To spread out your risk and have smoother returns, you may want to create a ladder of entries, or stagger expiration dates so you always have some options expiring every couple of weeks. This way if a big spike is developing in the middle of your expiration cycle, you already have some capital ready to throw at it and take advantage.

Note I am generally NOT trying to sell an in-the-money call. Why would I? I already know the average amount of loss UVXY can expect in that span of time, so my premium should reflect the amount I would expect UVXY to lose. If the trade does not go as planned, and I see UVXY rise over 14, at least I've already collected the amount of money I should have for that period of time and now have the option to short shares directly at 14.

Finally, going for a more aggressive, lower strike can give more premium up front, but also increases the likelihood of being assigned short shares, and at a poorer price. If I'm a short seller and I want the shares, why not try to sell at the best price possible? Remember I am merely trying to synthesize a core short volatility position – the short equivalent of buy and hold. I'm not trying to aggressively trade this by timing it or daytrading it.

Of course, the art of option selling is trying to find the balance between premium collected and probability of the trade success. If you feel UVXY will move downward more rapidly, you will expect a larger percentage move and you'll be allowed to place your trade closer to money for more premium. If you are expecting UVXY to trade choppy or in a range for a few weeks, you may settle for lesser premium but you'll be allowed to go further out of the money and increase your chances that you will keep your entire premium collected.

Finally, waiting to sell options until volatility is actively spiking will allow you to sell options for greater premium. This will allow you greater flexibility in choosing lower risk strike prices, and getting a fatter paycheck. And who doesn't like a raise?

Happy VIX trading!