At this point, unfortunately, we all know markets can move higher in spite of logic, valuations or anything else. As markets move higher, volatility has been falling. This may make for a good time to become bullish on volatility.
Volatility is mean reverting, we know that. However, it can remain low for long (and painful) periods of time. If we want to add a bullish volatility trade it is important we collect premium in the process. That does not mean we can only sell credit spreads. What we mean by collecting premium is, if we opt for a debit spread, we want to lower our cost.
There are various strategies for getting long volatility. Different strategies will affect buying power, profit potentials and probabilities of being profitable differently.
As an example, one way to get long volatility is buying options in VIX, the cash volatility index. Such a trade may look like this:
Buy VIX 16 calls and sell VIX 19 calls for a $1.05 debit with 56 days until expiration (DTE).
Buying power reduction for this trade will be the cost of the debit or $105.
Our max profit is the width of the spread less the cost of our initial debit or $195.
Probability of being profitable is 65%.
We can also look to sell puts in order to finance a call spread:
Sell VIX 16 puts and buy VIX 12.5 puts then buy VIX 17 calls and sell VIX 20 calls for a $0.30 credit with 56 DTE.
Buying power reduction for this trade is $326.
Our max profit is defined by both the credit spread sold and debit spread purchased or $330.
Probability of being profitable is 58%.
Finally, we can also look to incorporate futures in our trade by purchasing the VIX future then selling a call spread in VIX options. The challenge with this type of trade, especially in an IRA, is buying power. Buying a VIX future in an IRA costs about $6200. Selling a call spread will generate a credit; however, it will cost an additional $1200 or so in buying power. On the other hand, this trade would be the most profitable in the event volatility were to spike.
As tastytraders, what we should take from this is, getting long volatility can be accomplished in many ways. We are contrarian traders to begin and we also understand volatility is mean reverting. For us, getting long volatility at these levels makes a lot of sense. It does not mean volatility will accommodate us but when volatility becomes this cheap and equity prices reach all-time highs, pot odds of getting long the market make little sense. However, getting long volatility does make sense.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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