Trade Volatility As If It Were a Stock

Option traders buy and sell two elements: time and volatility. Many option traders, myself included, rarely touch the underlying security. The closest we ever get to owning a stock is to own deep-in-the-money calls; shorting a stock means buying deep-in-the-money puts.

Unlike stock traders, pure option traders rarely suffer from exposure to the market's direction. They often structure positions on both sides composed of puts and calls, long and short, in complex structures that are both direction and delta-neutral.

VOLATILITY RISK

But those of us who purely trade options have a different problem: We are constantly exposed to the risk of rising or falling volatility. Consider, for example, a trader who focuses on condors—one of the most popular option structures composed of a short strangle bracketed by a wider, less expensive long strangle. Condors are a bet on falling or stable volatility because they generate profit from stable time decay; rising volatility is the enemy.

But hedging a portfolio of condors or other trades that are short volatility is difficult. Until recently, the only choice was VIX options. But VIX options are European style expiration and often illiquid. Sometimes the spot VIX rises and out-of-the-money call prices barely budge because sellers are under no immediate pressure to close their short positions until expiration.

As these words were being written, the spot VIX was 17.67. February 18 calls were priced at $4.60 (220 percent implied volatility), but February 18 puts were worth only $0.25 (0 percent implied volatility) despite being in-the-money.

VIX FUTURES

The alternative has been to hedge with VIX futures. Unfortunately, not all option traders are experienced futures traders, and trading VIX futures can be a complex problem when they are being used to hedge a portfolio with specific expiration time frames. Trading futures involves understanding two important dynamics: contango (near expiration less expensive than far), and backwardation (near expiration more expensive).

AN ALTERNATIVE SOLUTION

Luckily, thanks to Barclays Bank PLC, we now have an alternative investment vehicle that tracks a blend of futures contracts on the VIX. There are two choices, VXX (short term) and VXZ (mid-term). Each is an Exchange Traded Note (ETN), an unsecured debt security issued by Barclays that trades like an ETF:

•iPath S&P 500 VIX Short-Term Futures ETN (VXX): Designed to track VIX short-term futures by providing a daily rolling long position in the first and second month VIX futures contracts.

• iPath S&P 500 VIX Mid-Term Futures ETN (VXZ): Designed to track VIX mid-term futures by providing a daily rolling long position in the fourth, fifth, sixth, and seventh month VIX futures contracts .

ETN STRATEGIES

Option traders who sell volatility in their portfolio can use these ETNs as a hedge. Furthermore, differences between long- and short-term views of the market often suggest more complex strategies. It might make sense, for example, to short the near-term VIX while being long mid-term. If the market becomes unstable, interest rates rise or the recovery sputters, those dynamics are likely to be more heavily represented in VXZ than in VXX.

Another choice might be a collar (long the mid-term ETN (VXZ), short current month calls and long current month puts). The trade can be renewed each month as the options expire. If the view that forward looking futures prices are likely to climb faster than the spot is correct, then this trade should deliver a hefty profit as the gain from VXZ will outperform the loss from the sale of calls on the index.