VXX Put Options Don't Work in a Market Crash

Video Transcript:

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So we all watched that huge volatility spike last Friday and Monday with some excitement. For the volatility product called VXX, it was the seventh and then the first largest spike going back to the VIX futures launch in March 2004. It was a really big deal.

Now anytime this happens, the first thought that pops into traders head is, well, I should buy some long put options on either VXX or UVXY, right? After all, we all know they're going to go back down long term. Here's the VXX back to 2004, and it's down 48% a year. The 1.5x leverage UVXY is down 68% per year.

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So we all know that eventually, maybe in a few weeks, maybe not for a few months, but eventually it is going to go back down. Today I want to show you why buying long put options is not the way to set up a short volatility trade after volatility has spiked up. So you have to remember that when you're trading options, it's not just about the price movement.

Leave that to the stock pickers. It's pretty binary. It's either up or down.

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But for option trading, there's many variables we're dealing with here and many option Greeks to describe them. But fortunately, you really only have to know three of them. Delta relates to the directional component of a trade, the price action.

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Theta is the time factor and how much an option's value will change given the passage of time. And then the one we really need to focus on when volatility spikes up really high is Vega. This is the volatility component.

Vega measures how much an option's value will change given a 1% change in volatility. This is the important thing you have to remember. Long put options are strongly Vega positive and they are strongly Theta negative.

For the Theta, long put options lose value every day. For the Vega factor, if you buy a long put option after volatility has seen one of these massive spikes, you are buying a very expensive option. What ends up happening is, even if you get the direction right and that VXX or UVXY, it does eventually go back down just like you thought it would, over time and as the market calms down, that option's going to lose a ton of value.

Simply put, even if you get the direction right, you can still lose money on your trade. Let me show you what I mean. So here's the VXX in the last two years.

And of course, one look at this chart tells you why we want to short volatility in our VTS portfolio. We have 25% allocation to our tactical volatility strategy. Now it does have a long volatility component that we can use to profit from market crashes, but it is mainly driven by the short volatility positions.

The VXX goes down long term, the inverse volatility products go up long term. This is why we dedicate a portion of our portfolio to short volatility. But when it does actually spike up, this is when traders look to fade it because it mostly does go back down before long.

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Now there will be times when the spike lasts a while and they can go up several hundred percent. You want to be very careful. If you're using options, you want to give yourself some time for this all to play out.

But fading the volatility spikes does make some sense, right? So let's just mock up a long VXX put position. Go to the analyze tab here. And like I said, we're going to give ourselves enough time for this to play out.

So this October contract was 75 days. This will work just fine. Now I do have some trades already open.

As you can see, we're just going to ignore those for now. But let's say somebody thought the VXX would go back to its recent position in, say, a couple of months. It was around 40 not too long ago.

I think it's pretty realistic to assume that it might get back there in a month or two. So if we go back to the analyze tab, we could mock up something like a long 50 strike put option just to see what that looks like. Now we'll have to adjust something close to the mid price.

You can see 550, 670. Let's just call it 610. This is what that looks like here.

So the current price is here. It spiked up all the way to almost 63. But here's that 40 range where it was at just a few weeks ago.

This is a long put option. It's delta negative. So of course, we want the VXX to go back down.

And it actually looks like this trade could make a decent chunk of money, right? If we get the direction right, we should be good to go. The problem is, like I said, the theta and the vega. So the first thing is if we just look at the theta, you can see this is a theta negative trade.

So it's actually going to lose value with every day. As this thing gets closer to the expiration, you're just going to be losing value slowly over time. And more importantly, if we look at the vega, the volatility component, it's very positive vega.

So again, this is not a good thing because if the market does actually calm down, that vega is going to be pulled out of the option and it's going to lose a lot of value. In the thinkorswim platform here, I can actually show you what I mean. So if we go to the option again and we go up here, we can see that the current volatility level is about 110%.

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But a couple of weeks ago when the VXX was near these lows, an option with that much time frame was probably about 60% volatility. Remember, vega represents how much an option value will change given a 1% change in volatility. If we lose 50% of the implied volatility in this option over the next couple of months, that could be very costly.

So let's run both of those adjustments. The first one, you can see the date here. Let's say we go forward two months.

You see how that dropped down right there? Well, that's because the theta is going to eat away at some of the value over time. We're expecting that to happen. The passage of time is working against you.

But then we can also do a volatility adjustment. So if we go here, watch what happens to the pink line when I do minus 50% volatility. Well now it's also dropped down and a lot of the value in this option has been sucked out.

So now we're at a point where even if it does get to 45, you're still going to lose a little bit of money. The only way this long put option could make any money at all is if it crashed down extremely quickly. But if it gets anywhere close to the expiration, even within a month or so, this option will probably still be negative even if the VXX bleeds down to the 45 level.

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Long put options after one of those huge volatility spikes has a massive headwind. And remember, this doesn't just apply to last week. This is any time going forward when you see one of these big spikes.

Long put options have a huge theta and vega headwind. You're going to need your underlying security to go down more than expected and faster than expected to overcome that big headwind. The bottom line is when you're trying to fade volatility spikes, you need to choose an option spread that has both long and short strikes built into it to reduce those negative effects.

Now in my last live stream, episode 89, for anyone who missed it, I'll leave a link here. And by the way, you should tune into our live streams because you can ask questions. But in episode 89, I showed a vertical put spread, which is a far better choice than a straight put option because it's relatively vega neutral.

It's comprised of both a long and a short, so that vega largely cancels out. And I showed a butterfly spread, which is even better because it's vega negative. Those middle strikes on the butterfly are short options, which makes it a vega negative trade.

Now you can see that not all methods of shorting volatility are created equal. The market's not consistent from week to week. There are times when an iron condor is the best trade.

There's also times when a vertical spread will be the most efficient. And yes, there are even times when long put options have an advantage. But definitely not immediately after a large volatility spike.

If you do that, you are just walking headfirst into a theta and vega headwind that's going to be very difficult to overcome. You need to match your trade to the current market environment if you want to maximize your profit. So next you'll want to watch this video that breaks down my UVXY butterfly strategy within the VTS portfolio.

There's also a full course that goes with it, so definitely claim your free trial to the VTS community. You can access your full course library and see all of our live trades. Thanks for watching.