Event Trading with VIX Put Options
I created a trading rule that can achieve high returns in a short period while being relatively safe using VIX. I tried it in October and it seemed to work well, so I'll summarize it in this article. It's a mentally gentle method suitable for beginners.
Note that you need to understand options, so if you're not familiar with them, please study and read this article. Also, you'll need a US securities account like IB Securities to trade.
What is VIX?
VIX is a unique index that can be said to represent the anxiety of market participants. More accurately, it's the expected annual volatility of the S&P 500 over the next 30 days, but we won't go into details here.
VIX has the characteristic of being generally low most of the time. Usually, it's around 20 or below. When the US stock market plummets, it surges, and then returns to its original level after a while. Sometimes, it exceeds 40 and takes a long time to return. It's not clear why this happens, but it might be due to market sentiment or volatility...
VIX 1 year
VIX 5 years
(Image from Yahoo Finance: https://finance.yahoo.com/quote/%5EVIX/)
By the way, VIX's price can fluctuate by 10% in a single day. If it suddenly rises from 20 to 30, that's a 150% change. There's no concept of a "stop-loss" here, so it can move freely.
Trading Strategies Using VIX
Looking at this graph, the following strategies come to mind:
- Buy when it's low and sell when it's high
- Sell when it's high and buy back when it's low
However, strategy 1 is not recommended, and strategy 2 is also problematic.
Issues with "Buy Low, Sell High"
First, VIX is an index without a physical entity, so you can't hold it for a long time. When trading, you need to roll over your position, which incurs rollover costs. You'll need to pay these costs indefinitely, and you'll also need to roll over your position every month.
Additionally, if you hold your position for a long time, your funds will be tied up. In an environment with high US interest rates, it's painful to keep your funds tied up in a futures contract.
Issues with "Sell High, Buy Low"
On the other hand, this strategy has the advantage of being able to predict when the market will fall. If the market doesn't collapse, it usually returns to its original level within a week.
However, if you sell a futures contract and try to make a profit, you'll face the risk of loss-cutting. For example, if you sell at 20 and the price drops to 15 after a month, you might think you've made a profit, but if the price suddenly rises to 30, you'll incur a significant loss. In the past, VIX has exceeded 40, so this is a real risk. Moreover, VIX often moves significantly outside of trading hours, so even if you set a stop-loss, it might not be triggered at the desired price.
For example, if you sell one contract (1000 units) at 20, you'll need 20,000 dollars (although this amount will be reduced in a margin trade). If the price drops to 15, you'll gain 5,000 dollars, but if it rises to 30, you'll lose 10,000 dollars. In this case, you'll need to prepare 1.5 times the amount of your desired position (30,000 dollars) to avoid being forced to close your position.
Using Put Options
This is where put options come in. By buying a put option, you can pay a premium to ensure safety.
Here are the specific rules:
- When VIX exceeds 25, check the option prices
- Buy a put option with a strike price above 20.0 and an expiration date over a month
- Decide on a profit-taking price beforehand
- Close your position or take profits one week before expiration
- Cut losses one week before expiration
It's simple.
Example
Puru-san bought a put option when VIX exceeded 25. The 33-day 26 PUT was priced at $6.0, so he bought 10 units. He set a profit-taking price of 15 and went to bed.
(1) 20 days later, VIX dropped to 15, so he closed his position. Since it was deeply in the money, the time value was negligible, and his profit was almost 5,000 dollars.
(2) 20 days later, VIX rose to 22. Since it was at the money, the time value increased, and he could close his position at the same price.
Merits
The biggest merit is that losses are limited. Of course, you won't incur losses exceeding the premium you paid. This makes risk management easier and helps you take positions that fit your risk tolerance.
Next, closing positions is easy, which is gentle on beginners. If VIX approaches the strike price near the expiration date, the option will be in the money, and the time value will increase, reducing losses. Closing positions is very easy, and you can rest easy.
Finally, profits are easy to understand. When you buy an option, you can decide on a profit-taking price, such as "I'll take profits when VIX reaches 15." This makes it easy to understand your potential profits and losses, allowing you to make trades with a clear risk-reward ratio.
Note that the liquidity of options is a concern, but VIX has exceptionally high liquidity due to arbitrage and market-making bots. The spread is usually around 0.1 (the minimum unit).
Demerits
While there are merits, there are also demerits.
First, premiums are high. Since VIX is high, the implied volatility is also high, so you'll need to pay a high premium. Additionally, you'll need to hold the option for a certain period to ensure safety, which means the time value will also increase. These two factors will reduce your expected returns.
Moreover, opportunities are limited. This strategy is only effective when VIX is high, which doesn't happen often. You can't rely on this strategy to make a living.
Conclusion
I created a trading rule that uses VIX put options to achieve high returns while ensuring safety. While opportunities are limited, the strategy has a short capital lock-up period and can create profit opportunities during market downturns, making it worth considering.
