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Profiting with VIX spreads in Market Crashes

by David LeVine
When the Market goes down quickly, the Volatility goes up quickly.

We have a special VIX Options trading strategy to profit from these spikes in Volatility.

The VIX measures the volatility of the options prices on the S&P 500 Index (http://www.cboe.com/micro/vix-and-volatility.aspx).

When there is FEAR of large price movements, like when the Market is going down, the options prices will go UP. The VIX is the gage of that fear.

The VIX is NOT a stock, and it does not act like a stock.

When the fear goes up, the VIX goes up. Eventually, things calm down and the VIX will drop back down.

10 year VIX chart:
10 year VIX chart

Back in the crash of 2008, the market was in 'melt down' mode and it took a long time for the market to recover - which is reflected by the very high VIX values that took time to come down.

However, if we look at this more recent 5 year span, the market was relatively calm. The VIX was mostly in the 15 range, with small spikes of volatility.

5 year VIX chart:
5 year VIX chart

Our VIX strategy relies on the historical fact that when the VIX spikes up, eventually things calm down, and the VIX will return to a more normal range.

This strategy depends on the fact that the market will not stay in panic mode forever. The market prices eventually settle out. We can understand this logically, because if the price of the options are very high in a calm or 'bottomed out' market, there will be a lot of Sellers of options, but no buyers willing to pay the high prices. The normal market forces will reduce the options prices, and the VIX (fear) will drop down to a normal range.

When the VIX is above 20 we consider trading the VIX.

When the VIX is above 25 we consider this a GREAT VIX trading opportunity.

We make a VIX Call spread, but we make a spread that is IN THE MONEY. Remember from above that the VIX is not a stock; the fear and options prices will naturally come back down through normal market forces.
This is an unusual trade for us. We only trade Condors In The Money on the VIX in this type of extreme volatility.

We select spreads that are IN THE MONEY, or at least PARTIALLY IN THE MONEY because we want to collect as much premium as possible.

--> We prefer spreads that are as high as possible, where at least ONE Strike is IN THE MONEY.
Higher strike spreads will close earlier as the VIX drops back down, so there is less risk.
Higher strike spreads also give flexibility through rolling out to later expirations if the VIX doesn't drop quickly. You can roll out to a lower strike without losing money on the roll (in some cases).

Warning: You can make more money if you pick spreads where the Short strike is below 20. However, you take more risk on lower spreads. The VIX might not drop down fast enough to close your position early, and you may be forced to adjust by rolling out to later expirations, which can cost a lot of money.

--> We want the entry Credit to be AT LEAST DOUBLE our target profit.
If I target a 10% profit on a 5 point spread ($500 maintenance on 1 contract): The entry credit must be at least $1.00. This means I can set a GTC limit order to close the position for $0.50, which will leave me with a $0.50 per share Net Profit: $50 Net Profit on 1 contract, which equals a 10% return on the maintenance amount.

--> We prefer the VIX expriations that are 40 to 60 days away.
The VIX does not have as much Time Decay as an Index or Stock because of it's reactive nature. So taking positions at later expirations gives your trade more time, with minimal extra cost.
It's important to take advantage of this unusual benefit on the VIX.

--> Monthly expirations are preferred over Weekly because of greater liquidity. We start with Monthly but Weekly are OK if there are better trades.

--> We select 3, 4 or 5 point spreads, so the Commissions cost is relatively low compared to the amount of premium we take in.
The Commissions cost should be similar to a 'Sales Tax' in proportion to the target profit amount. If the commission cost is too high proportionally, then make your spread wider to take in more premium.

We place GTC limit Debit orders to close the spreads early.

Depending on the price movements & VIX levels, our exit orders will leave us from 10% to 20% profit on normal trades - and up to 40% profit if the VIX goes above 40.
(The Profit is based on the Maintenance amount of the trade. The maintenance amount is the maximum loss - if both strikes EXPIRE IN THE MONEY.)

Prior to the 2016 Presidential elections, there was a short Market drop which caused the VIX to go up.
On Sunday, November 6, 2016, we looked at the DECEMBER 2016 Monthly VIX expiration (44 days until expiration).

The VIX reached 22 at this analysis point:

VIX Trade Finder from November 6, 2016 - for DECEMBER 2016 spreads: (See in Trade Finder).
Selecting a VIX spread

Based on the Friday closing prices in the image above, I would take the 21 - 24 Call spread (3 point spread = $300 maintenance per contract) for $0.60.
After I was filled, I would place a GTC Limit Debit order to close for $0.30, which would leave me with a 10% profit.

--> If couldn't get filled on the above, I would drop down to the 20 - 23 Call spread (3 point spread = $300 maintenance per contract) for $0.65 (Your spread prices must be in $0.05 increments on the VIX).
If filled, I would put a GTC Limit Debit order to close for $0.35, again leaving a 10% profit.
(The thinking here is to have a higher GTC order price because I am ONE point lower on the VIX than I wanted originally.)

--> If I couldn't get filled, I would drop the price down to $0.60, and have a corresponding $0.30 GTC Limit order to close.

--> If couldn't get filled on the above, I would go back up to the the 21 - 24 Call spread for $0.55.
After I was filled, I would place a GTC Limit Debit order to close for $0.25, which would leave me with a 10% profit.

--> If those didn't workout, I would change the spread width to 4 points or 5 points, so I was negotiating on different LONG strikes.

To summarize our VIX Call spread selection goals:
==> We want our Call spread to be as far up the Options chain as possible, with our Short Strike still IN THE MONEY.
We want these trades to close quickly, and to give ourselves the maximum amount of adjustment leverage if the VIX stays high.

==> We want the spread (difference between the Short Strike and Long Strike) to be WIDE enough that the COMMISSION cost is not a major factor.
That means that we need to take in enough profit that the round trip trade commission cost makes sense (similar to a "Sales Tax" in terms of cost).
One and Two point spreads are hard to get that to work, so we will generally select 3, 4 or 5 point spreads.

==> We select the Expiration that is 40 to 60 days away, starting with the Monthly expirations because of increased liquidity.

==> We want our GTC Limit Debit orders to be at least 50% of the Credit we take in.

==> We want the profit to be at least 10% because of the risk of adjustments & the possibility of waiting for this trade to close.

If the VIX keeps going up, we ADD MORE VIX POSITIONS at higher strikes, and sometimes at later expirations.

If you remember from above, these are unusual trades and we are banking on the market eventually calming down - or reaching zero, in which case it can't drop any more.
If the VIX keeps going up, that is our opportunity to keep adding more great VIX trades.

** Of course, adding more VIX positions is not appropriate for everyone, and you need to trade smart.

Here is how we deal with a VIX that won't go down:

--> These trades require patience.
It can sometimes take weeks for the market to calm down and for the VIX to come back down.
If the trade hasn't reached the adjustment point, be patient.

--> We adjust EARLY.
When the EXPIRATION date of our options is 21 days away or less, we adjust the position.

--> We adjust by rolling out the spread to a later expiration.
Ideally, we roll out to the same strikes about a MONTH LATER with little or no cost on the roll. If the VIX is really high, you will want to take a later expiration.

You can roll to a spread 1 or 2 points lower to minimize cost.

Don't try to take in extra credit on the roll by going for lower strikes. You want your spread to stay as HIGH as possible so it will close early.

--> If the VIX went really, really high, like in 2008, then roll out as far in the future as looks reasonable: could be 6 months or more.

--> Be prepared that if the market really crashes, you will stuck in these VIX trades for a long time.

--> Be aware, that you can LOSE money on the rolls to later expiration dates.
** Under extreme circumstances you could lose more than the maintenance amount of the original trade.

--> Keep in mind that the VIX has an unusual TUESDAY expiration.

--> As with all of your OPTIONS trades, you should be prepared to close the position for a loss.
Only trade with funds you can afford to lose.


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