Going Long Volatility – Puts Vs Calls

As anyone who knows me knows, I’m a premium collector.  I primarily sell options short to collect their premium.  I also try to place directional plays when I do it.  Together, this means that the majority of my profits are from theta decay (premium) and delta (direction).

Because puts typically have higher premiums than calls, premium collectors tend to sell more puts.  When possible, we sell naked puts to maximize profits and the probability of profit by having a lower break-even point than if we sold verticals.

Thus, to play a rise in volatility, I waited for a rally to bring UVXY 6,89 +0,17 +2,53% below $26.  That happened yesterday.  On that trade, I hope to collect 75% of max profit for a 12% ROC in two weeks.

Being in a margin account, my maintenance requirement was lower than in a cash secured IRA.  In the IRA, even with max profit, the ROC is only 8.3% due to the increased capital requirement.  Note that being a 2x ETF, this has twice the maintenance requirement in a margin account that a 1x or stock.

So, when a friend said he was looking for a way to benefit from the rise of UVXY, while still enjoying the lower break-even point of the naked puts strategy, but with lower capital requirements, I came up with another call based strategy that uses a fraction of the capital to have nearly the same risk/reward profile.  Like short puts, your max profit is primarily derived from premium.

This strategy is especially beneficial in UVXY, because unlike most underlyings, long volatility derivatives tend to have more premium on the call side.  This is because many people are betting on volatility taking off when it is relatively low.  In August, for instance, UVXY spiked to $91.  Two weeks ago, it hit $43.  It was in the 20s before each of these spikes.  (Keep in mind, that due to contango loss, UVXY tends to lose 5% of its value each month, typically when the market is bullish.  Do not presume that the 20s will always be a good buy price, or that you can just hold it long-term.  UVXY is a terrible buy and hold, especially in a bull market like 2013.)

The key to this call strategy is understanding delta.  Delta is the amount an option is expected to change in value when its underlying changes by $1.  This value can range from 0 to 1. Far out-of-the-money (OTM) options approach 0.  Deep in-the-money options can have a delta at or near 1.  At-the-money options typically have a delta near 0.5.

It is also important to understand that premium is highest at-the-money.  An option with a delta of 1 has no significant premium, and acts like the stock.  Thus, if the stock goes up $1, the price of this option will typically go up $1.  This alone is a huge advantage in an IRA, as you can buy a delta 1 call to go long the stock at a fraction of the cost of buying the stock, while still having the same gain/loss as owning the stock.  Also, in an IRA, you can buy a delta 1 put, which has the same effect as shorting the stock, even though you can’t otherwise short stocks in an IRA.  Delta 1 options, in addition to using less capital than owning the underlying, have built-in loss protection.  You cannot lose more than the cost of the option.

Currently, UVXY is $26.80, and the strike 19 January call (expires in 16 days) has a delta near 1.  It’s bid/ask is 7.35/8.20.    Its intrinsic value is 7.80 (current price of UVXY minus the strike), which is right between the bid and ask.  This option has no premium, as its price is 100% intrinsic value.  Thus, you do not have to worry about time decay on this option, a normal con to buying options.

Buying this call requires 32.5% of the capital of buying the stock on a cash basis (no margin).  This alone provides an avenue to leverage in your IRA.  This synthesizes buying the stock, then buying a put at 19 to protect from loss, but without the cost of buying a put.  In UVXY, this isn’t that important today as we don’t expect UVXY to see $19 in the next 16 days.  In other stocks that could drop on news or a flash crash, this is an important benefit.

But, just buying the call doesn’t match the short put strategy with a lower cost basis.  If UVXY goes down $1 to $25.80, you are down $100 on 1 contract, the same as if you owned 100 shares.   This is purely directional with no collecting of premium.  So, how do you convert this to simulate a short put?

Simple, you create a long vertical spread by also selling a call nearer to the money, with a delta closer to 0.5.  Let’s consider selling a strike 25 call, currently trading for 3.80/3.90.

There’s one catch.  The vertical has a wide bid/ask spread and it’s hard to get the mid price on this because of the delta 1 option, as market makers only profit from the difference in the buy and sell prices for these options.  I was able to get a fill between the mid price and the ask on the vertical, or 75% between the bid/ask. When I put this in, I got a mid of 3.93, and a NAT or ask price of 4.40.  So, for the purposes of our analysis, we’ll consider obtaining this vertical for $4.15.  This means it will cost us $415 to buy this spread, and this is the most we can lose.  In order to lose $415, UVXY would have to be below $19 at expiration, which is very unlikely to happen in 16 days since it is tied to VIX futures.  In fact, unlike owning a stock, if UVXY did go to $19, but had, let’s say, 1 week to expire, being ATM, that option would have a premium and a delta of 0.50, meaning it still wouldn’t be worthless, yet.

The delta on the 25 strike is currently .65, above .5 because it is in-the-money.  Yet, because this is still near the money, it has a nice premium.  That premium is the difference between the strikes, and what we are paying for the spread.  In other words, the spread is 25 minus 19, or $6.  Yet, we are only paying $4.15.  This gives us a $1.85 premium on this spread.  That is our max profit.

Note that unlike naked puts, where we usually sell OTM options, we’re OK with this being ITM.  In fact, that lowers our break even point.  Our break even point is the strike of the short call, 25, minus the $1.85 premium, giving us a break even of $23.15.  Put differently, it is the lower strike plus what we pay for the vertical, $19 plus $4.15.  With UVXY at $26.80, this is still $3.65 below the current price of UVXY.  We can collect max profit if UVXY expires above our short call, or above $25, but can still potentially make a profit if UVXY is between $23.15 and $25.

You can see that this emulates selling a put with a strike of $25 for a premium of $1.85.  Currently, this put is selling for $2.10.  Thus, with the call spread, due to the lower premium, our break even is 0.25 higher than it would be with the put.  This gives the put a slightly higher probability of profit.  But, still, this difference is very small, and the capital requirement of $415 is much lower than the $2500 that would be required on a cash secured put.  Even with a margin account, where the maintenance requirement might be closer to $1600, $415 is still going to be a lot lower.

Because of the lower capital requirement, the return on capital (ROC) of this position if you make max profit is a whopping 44.5% in 16 days!  Even if you close this at 50-75% max profit, this is still a huge ROC, and might even be higher on a per day or annualized basis if you can close it quickly.

This only works because the long call has a delta of 1 and does not require you to pay a premium, while the short call pays a nice premium.  This means you collect premium on the short call, but don’t have to pay premium on the long call.  While this benefits from UVXY going up, you technically just need for it to stay where it is, above $25.  But, the higher UVXY goes, the quicker that extrinsic value of the short option disappears, permitting you to take profits sooner if your target is 50-90% max profit.

Because you are short an ITM option, you typically do not want to hold this to expiration.  Definitely close it at least a few days before expiration if UVXY is above 25, putting the short option ITM.  Only if it is OTM, that is UVXY falls below 25, does letting it expire worthless become an option.  This is ironically the opposite of a short put, where you could consider letting the put expire worthless if UVXY is above 25.

Typically, being short options ITM is not desired.  But, this one is covered by your long option being further ITM.  In other words, you could exercise your 19 call in order to provide the stock if the 25 call was exercised.  In this scenario, you are paying $1900 for stock you are immediately selling for $2500. That is why this position is relatively safe despite the ITM short call.

You can close the vertical by selling it, just like you opened it by buying it.  If you need to close the legs separately, always close the short call before closing the long call.  Otherwise, you’ll have a naked call.  If your broker has a ticket charge, you’ll save money closing it together in one order, as a vertical is typically treated as one order, and thus incurring only one ticket charge.

A scenario where you might close the short side without immediately closing the long side is if UVXY came down a lot, let’s say to $23, and the short call got cheap.  If you wanted to hold out in hopes that UVXY went up before expiration, you might buy back the short call, then let the long call ride on its own, hopefully going up.  If UVXY then jumps to over $25, your profit will likely be greater than the $1.85 max profit you originally calculated because you won’t suffer the loss of the short call then jumping back up in price as UVXY rises, nor will your profit be limited at that point.  One of the great things about options is it can be easy to turn a loser into a winner by adjusting the position when the opportunity presents itself.

To help you calculate the cost/risk, potential return on capital (ROC), and the break even price of the underlying, I created this Google spreadsheet.  Simply make a copy of the spreadsheet so you can edit it, and enter the strikes of the vertical, as well as the cost to purchase the vertical in the 3 yellow boxes.  It then calculates the rest.

To estimate the cost of a vertical, use your broker’s order system to create the order, then see what the estimate is.  You don’t actually have to place the order.

For instance, using TD Ameritrade’s Think or Swim (ToS) platform, you can see that it presents a mid price of 4.38, and a Nat (ask) price of 5.25.  Because this includes a delta 1 option, to ensure this gets filled, as mentioned earlier, I’d estimate this to be between these two numbers, or $4.85.  When I actually place it, I might try raise it a nickel at a time until it was filled, to try to get filled at the best price.  Note that this screenshot is after hours, so the spread is wider than it was during the regular trading hours (RTH).

In this case, the values I’d enter in the spreadsheet would be 19, 25 and 4.85.

I originally estimated this trade earlier in the day before UVXY went up significantly.  You can see in row 2 of the table below that the ROC was nearly twice as high then at 42.86%, had a lower break even of 23.2, a higher max profit, all due to a lower cost.  After market close, that ROC was reduced to 23.71% (row 4).