New option trades: Naked puts on VXX & BBT
I recently initiated two new short put option positions – one in a bank stock that’s down almost 40% from its recent highs and the other in a volatility ETN (see details below) that’s likely to have a negative correlation to the market. The latter position could be expected to act opposite to, and as a bit of hedge against, my other naked put positions, which are all in equities.
New positions:
BB&T [[BBT]] – On 8/25/10 I sold some March 17.5-strike put options for $1.05 against BBT as the shares dipped on market weakness:
BB&T is a large regional bank with more than 1,800 branches in the southeastern U.S. and Washington, D.C. serving consumers and small to mid-size businesses. Risks include exposure to the ongoing issues in the banking industry as well as possible effects from another economic downturn, while positives include the company’s strong operating history and conservative balance sheet.
Currently trading at about $23.5 and yielding over 2.5%, shares of BBT have fallen almost 40% from their May highs and are now at intermediate-term oversold levels. Further downside in the coming days/weeks could result in positive divergences in the oscillators, but in any case the current extreme levels suggest the possibility that a bottom of some significance could be near.
Fundamentally, with a current average calculated fair value somewhere in the low $20s, BBT doesn’t appear especially undervalued here. However the current price appears to be a fair reflection of next year’s expected earnings, which are expected to be over $2.00 per share on average. In addition, the company recently indicated the likelihood of a dividend increase perhaps as early as the end of this year or early next year.
If the put options I sold against BBT expire out-of-the-money (OTM) my return will be about 5.7% in 7 months, or about 9.8% annualized. If I’m ultimately assigned the options and put the shares, my net cost basis will be about $16.50 with a corresponding dividend yield of about 3.6%.
iPath S&P 500 VIX Short-Term Futures ETN [[VXX]] – On 9/3/10 I sold some December 17-strike put options for $1.15 against VXX (top graph, below) as it dropped as the market continued its recent rally:
The iPath S&P 500 VIX Short-Term Futures ETN is intended as a vehicle to allow trading of market volatility – in this case through a rolling long position in first- and second-month VIX (CBOE Volatility Index) futures contracts. Unlike the VIX itself (bottom graph, above), VXX can be invested in directly. So for options traders, a short put option position in VXX will – in the event of an option assignment – result in the purchase of actual VXX shares rather than a cash settlement as in the case of being short options on the VIX.
An additional advantage of VXX options over those on the VIX is that the latter don’t reflect the actual value of the spot index itself, but rather VIX futures. The result is option pricing in the VIX that doesn’t follow the action of the underlying index, which can be disconcerting to say the least.
VXX, however, isn’t without its problems, the least of which may be the fact that it’s an exchange traded note – a debt security whose value could be affected by changes in the credit rating of the issuer (in this case Barclays Bank PLC). After the recent credit crisis this is a factor that can’t be overlooked.
Of more concern is an issue that stems from the constant turnover of futures contracts in VXX as the front-month contracts are sold to buy the second-month contracts. With the usual relationship of longer-term contracts being more expensive than shorter-term contracts (i.e., an upward sloping (or “contangoed“) term structure), VXX will likely have a tendency over time to incur losses as less-expensive expiring contracts are sold to purchase higher-priced later-dated contracts.
The steeper the upward slope of the term structure, the more negative this rollover cost will be. And although periods of downward sloping (i.e., “backwardated“) and flat term structures do occur – resulting in positive or neutral roll yields, respectively – they’re not the norm.
The key takeaways from all this are that VXX may have a downward bias over time and that VXX levels – unlike those with the VIX – are relative and not necessarily meaningful. In other words, VXX is probably not suitable as a buy-and-hold investment hedge.
With that in mind I entered into this relatively small short put option position in VXX as a trade. If the put options expire OTM, my return will be about 6.5% in less than 4 months. However I won’t be slow to take profits early if given an opportunity, or to roll the position down if VXX continues to drop down to or below the strike price in the coming days/weeks.
If VXX goes lower, instead of rolling down the put, what about adding to the position, sort of like scale trading. Can VXX realistically go below 10? (VIX low is about 10)
Unfortunately, due to the futures contract rolling costs that VXX is subject to (see above), I don’t think there’s any particular limit to how low it could potentially go. This “roll cost” also means there’s no fixed relationship between levels on the VXX and VIX, so comparing the two without taking into account VXX’s likely downward bias could prove costly. Notice even now how the VIX (currently at about 23) is well above its April lows of 15, while VXX is already trading well below its April lows.
You mean that if the VIX stays low for an extended period of time (around 10 level), VXX would still continue to drift lower because of the rolling futures contract? There still has to be some lower bound, like 0 right? Also, if one decides to sell a covered call, wouldn’t this more than offset the cost of the rolling? I’m just thinking that unlike a stock, volatility wouldn’t go to zero and would eventually mean revert, and there probably is a way to safely put on a vol trade at very low levels.
Yes, if VIX flat-lined and the VIX futures on which VXX is based remained in a normal relationship – with front-month contracts being less expensive than second-month contracts – VXX would continue to experience a downward bias from the roll cost. This doesn’t necessarily mean VXX would automatically continue to drift lower – market factors may swamp out the roll cost (at least temporarily) – but it does leave open the question of just how low VXX can go.
I’m not sure there’s any reason to think it couldn’t eventually approach zero. However I’d assume at some point the underwriter would take action to adjust the VXX price. But of course any solution (perhaps a reverse split?) would do nothing for those who were long VXX at higher levels.
I think selling covered calls against a long VXX position could certainly work as a trade (just as selling put options could). However if someone wants to be long VXX as a buy-and-hold hedge against volatility in their stock portfolio, selling covered calls against it will tend to defeat the purpose by limiting VXX’s upside potential.
I’m looking at VXX as a standalone trade, not as a hedge to my portfolio.
Ideally I want to keep the VXX position open because at any time vol can explode. I want to try to balance the amount of covered calls to pay for the drift with the upside potential gain, which could be huge if uncovered.
I just think that there must be a reasonably safe way to play when volatility is at a very low level. If VIX remains flat, and VIX futures expectations remain flat as well, what could I expect the cost of the drift of VXX would be as a percentage of its price?
Thank you for your replies.
The amount of the drift will depend on the relationship between the near-term VIX futures contracts, which will vary – and even potentially be positive in some circumstances. However I did find one reference (http://vixandmore.blogspot.com/2009/10/why-vxx-is-not-good-short-term-or-long.html) that mentions a loss of “a few cents each day” when the VIX futures are in a typical upward-sloping relationship.
If the term structure of the VIX futures is flat, then the rollover cost should be minimal. However, I’m not sure how likely this would be in the case where volatility is already at a very low level.
All that being said, I would expect much of this to be reflected in the prices of VXX options (just as dividends etc. are reflected in equity option pricing).
I’m still thinking that continued covered call (short naked put) on VXX could be a viable strategy at low volatility points, with the premium overcoming the decay. But I’m also looking at the pair trading VXZ/VXX because the shorter term VXX decays faster. Here’s an article:
http://seekingalpha.com/article/196581-hedging-equities-with-vix-futures
Thank you for the conversation.
I think going long VXX at low volatility points (i.e., maybe VIX under 17-18) and selling covered calls against part of the position (or selling additional naked puts) to help offset a further decline in the underlying could be a viable approach if managed carefully. Especially if this includes an awareness of the roll cost factor and the fact that VIX can remain at very low levels for years at a time.
Pair trading VXX/VXZ sounds like an interesting approach, but is more complex and beyond the scope of my focus on collecting option premium. Best of luck in whatever approach(es) you decide to use. It sounds like you have a good handle on the issues involved in either case.