Going Behind the Scenes on a Winning UVXY Options Trade

Examing the factors that contributed to a big options win on leveraged volatility ETF UVXY

Jun 23, 2017 at 2:46 PM
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Ahead of May's monthly options expiration week, subscribers to our Expiration Week Countdown received a bonus trade that deviated from the parameters of our usual recommendations -- not only in that the underlying asset was a leveraged exchange-traded fund, but also in that the trade itself was a vertical call spread (as opposed to our usual straightforward call- and put-buying recommendations on stocks and non-leveraged ETFs). This particular trade was a May 12/13 bull call spread on the ProShares Trust Ultra VIX Short Term Futures ETF (UVXY) -- and since the strategy achieved its target profit of 150% after only two days, we thought it would be useful to analyze here some of the key factors that played into this successful options trade.

RECOMMENDATION: Following the entry guidelines as laid out below, place a day limit order to BUY (to open) the ProShares Trust Ultra VIX Short Term Futures ETF (UVXY) May 19, 2017 12-strike call, and simultaneously SELL (to open) the UVXY May 19, 2017 13-strike call at a debit of $0.36 or better. At the close on Friday, May 12, the UVXY May 12 call was offered at $0.70, while the UVXY May 13 call was offered at $0.35. UVXY closed at $12.41 on Friday.

This recommended vertical call spread trade can be described as "bullish on UVXY" and thus "bullish on volatility," but such broad statements need to be taken in a very limited sense. UVXY closed on Friday at $12.41, and this trade reaches its targeted profit of 150% on a rally by UVXY to $13 or higher -- and if you are familiar with the wide swings in UVXY, then you know this is indeed a very minor "rally."

In fact, this vertical spread (through its maximum entry price) has been designed to break even if UVXY finishes flat on May expiration Friday -- compared to its close on Friday, May 12. And it is this attractive reward to risk parameter that is the major driver for this trade recommendation -- namely, that very short-term premiums for volatility-based options has rarely, if ever, been priced cheaper than it was at the market close on Friday...

Per the original trade notes above, the trade would have broken even if UVXY finished flat, and it profited when UVXY rallied -- so there were multiple outcomes possible for the underlying's direction that did not involve a loss on the trade. I'd describe this as having been a function of the general benefits of trading verticals (as opposed to the straight purchase of calls or puts), plus some added perks provided by applying this strategy to UVXY calls.

In the more general sense, I'd say a vertical spread trade that does NOT provide (relative to straight purchases) a significantly lower bar for breaking even at expiration, plus a similar lowering of the bar for achieving doubles (and, in my world, triples), is one that's simply not worth taking. But since we never receive "something for nothing" by adopting an options strategy, the advantages of the vertical on the big profit side will begin to disappear once the higher strike is exceeded, and the straight purchase will eventually provide superior gains as the vertical reaches its profit potential cap.

The above cited areas of advantage for the vertical strategy are even further accentuated when we purchase a vertical call spread on UVXY (subject to a partial disclaimer to be discussed later), because implied volatility begins to soar at call strikes further and further out of the money (in other words, there is a "positive volatility skew" for UVXY calls similar to the "negative volatility skew" for SPY puts). These big skews exist because UVXY call players are heavily drawn by the chance for achieving tremendous upside in a very short time frame.

So if you felt (as many who play UVXY weeklies actually do) that UVXY could rally to $15 or $16 by Friday, 5/19, then why mess with the 12-strike call when you can achieve all that extra leverage (at lower dollar cost) with the 13 strike? But it doesn't stop there -- and so the demand for strikes of 14 and 15 and higher is such that IVs tend to soar at the higher strikes. But our purchase of the 12-strike call and our concurrent sale of the 13 strike in effect said to these wild-eyed volatility bulls, "You can have all that blue sky above $13." And we were paid handsomely for doing so -- in terms of a very cheap call vertical for which a 150% gain was very much achievable.

...One factor that may work in favor of this trade recommendation is the fact that the May VIX options expire on Wednesday of this coming week, which will remove almost 5 million open May VIX calls from the equation -- the replacement of which could exert downward pressure on the stock market through upward pressure on volatility levels.

Another point that has escaped much general attention is the fact that the VIX -- though admittedly reaching last week its lowest levels since 2007 (or since 1993, depending on your favorite financial media outlet) -- has been quite stable in the 10-11 range since May 1. And continued VIX stability is a prerequisite for the success of our recommended UVXY vertical call spread trade...

Let's talk about this description of "continued VIX stability" as a "prerequisite for the success" of this trade, given that we collected profits on a day where VIX spiked. The point I was getting at was that volatility-based instruments like UVXY have a built-in downward bias due to their obligation to continuously purchase higher-priced VIX futures contracts that eventually converge with "cash VIX" -- even if cash VIX traded flat as a pancake. But if cash VIX is at the same time declining steadily, then as a trader viewing an intraday chart, you'd swear you could almost see UVXY steadily deteriorating before your eyes.

And under those circumstances, it is a bit disingenuous to set up a UVXY call vertical and pat myself on the back for proclaiming that we'll break even at a level below the current price of the underlying. Because this "ain't no ordinary underlying" -- rather, it is one for which a decline between Monday and Friday of any given week is to be expected.

But if, in fact, the VIX had found some stability in the 10-11 area -- and it might actually RALLY toward the top end of that range over our holding period - then the deterioration in UVXY would either be greatly mitigated over our planned five-day holding period, or UVXY might even catch a little bit of a rally.

So by "prerequisite," I really meant that VIX stability was a necessary condition for taking this trade -- otherwise, what looked to be a "bargain vertical" was really not much of a bargain at all. But this was by no means a sufficient condition for taking this trade; you really had to believe you had better than a typical shot at experiencing some sort of VIX spike over the holding period.

Finally, implied volatility for UVXY options was (as of Friday, May 12) lower than 99% of such readings over the past 12 months (per Trade-Alert), and the 30-day implied volatility at 93.8% was a mere 2 points above the 52-week low set on May 8 (also per Trade-Alert). Historically low levels of implied volatility serve to increase the upside leverage for this trade (at UVXY prices approaching the 13-strike), and also serve (along with strict adherence to the recommended limit price) to reduce the break-even level for the trade.

As a final point of clarification: The historically low level of UVXY implied volatility that I had cited benefited buyers of UVXY vertical call spreads AND the straight UVXY call buyers. But the positive skew discussed above was only of benefit to those who purchase UVXY call verticals, and in many cases this skew was a major detriment to straight UVXY call buyers. And if this point makes sense to you, then you fully "get" the preceding discussion.

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