Vol Games

As I discussed with my buddy George the other day, FAZ is a hugely volatile stock, and it has a very active options market attached to it. I was encouraging him to take some profits off the table in his successful entry/timing on this day-traders’ delight.

[Please note:  I’ve known George for more than a decade, and know that his exposure to this stock is with play money only. That’s why I could feel comfortable suggesting a trading tactic to him.This post is the farthest thing from advice, since most readers will not be qualified to do what I’m doing – not even George.  For the pro’s and very liquid interested amateurs, this is what I’m doing, and you should really think about it and get advice before doing anything like this.]

As it turns out, I did a little swing trading in this monster, using options instead of the stock.  While I didn’t enter the position nearly as well as George did (the very best way to make money in the market is to get the timing right), I did take advantage of the run-up and run-down we’ve seen over the past week to lower my overall exposure and generate some cash.

On the run-up, I sold some $18 and $19 calls, for both July and January.  On the pull-back, I sold some $16 and $17 puts, for the same months.  My total sales were sized so that the net position has equal notional shares short and long, when you include the original cash long position in the stock.

After putting the position on, when the stock was trading at $15.93, I noticed that the net delta was zero.  For that brief moment, my position was perfectly neutral in the first derivative.  The second derivative is another matter entirely.

In one of the accounts, this is how the position looks today, with options valued halfway between the bid and the offer:

Long 500 shares, worth $7,750 at today’s price of $15.50.

Short 5 July $16 puts, worth $1,150 at today’s price with 35 days left.

Short 10 July $18 calls, worth $1,280 at today’s price with 35 days left.

Short 5 January $16 puts, worth $2,690 at today’s price with 224 days left.

Short 5 January $18 calls, worth$2,300 at today’s price with 224 days left.

My “net delta” (share equivalents) is currently +203 shares.

The total use of capital is just under $14,000.

So what happens as the market moves?  Both yesterday, when the stock was way down, and today, when it is slightly up, my position increased in value.

If, in the most beneficial of outcomes, the stock is between $16 and $18 as these options expire, I keep the premia I collected from selling the options.  At today’s prices, that’s $7,420.  That’s within spitting distance of the cost of the stock.

So, there being no free lunch, where’s the downside?

For the stock position, I think it’s obvious.  It can go up or down, with a bias toward down because the ETF is a 3x daily compounder, so a market swing up followed by down or down followed by up results in a loss of principal.  Do that enough times, and the stock will gradually go to zero.

For the options, it’s a little more complicated.  In July, the put and call premia are added to or subtracted from the strike prices to determine when you start losing money.  A $16 put/$18 call short strangle worth $3.60 per share today loses money if the stock settles beneath $12.40 or above $21.60.  That’s a wide range to at least break even with five weeks left.

The problem is that once you’re in a position to lose money in these things, you can lose a lot of money very quickly.  That’s why this is NOT for most investors.

For the positions out in January, the range of potentially profitable end points is much wider.

I get to keep all the option premium if the stock somehow lands on that third Friday in January between $16 and $18 a share.   However, with $9.80 per share in current value for those options, the range in which I don’t lose money widens out to $6.20 per share at the low end, and $27.80 per share at the high end.

None of this includes the commissions or the bid/ask spreads, which can be quite hefty.  For the long-dated strangle, I assume nearly $1 per share in “friction.”  For the strangle that expires next month, the market and the brokers suck out roughly 25 cents.

Still, with a few hundred dollars net outlay, I’ve created a position that can generate roughly $7,000 in profit, if, by some small miracle, nothing happens and the stock stays where it is.

Stay tuned.



2 Responses to Vol Games

  1. GeorgeR says:

    Bravo and thanks for the illustration.

  2. hhill51 says:

    An interesting supplement to the theoretical value of selling Vol on this puppy.
    All four of my open options positions ended up for the day (price of options went down). Given that the longer-dated options couldn’t both lose that much time value while the underlying declined, I saw an extra advantage to writing options of levered inverse ETFs:
    The underlying goes up when the market declines, and vice versa. But when the market goes up, volatility (fear index, remember?) goes down. As a result, the naked short puts in the strangle combo can go down in price, as they did today, even though the underlying stock is declining in price. This obviously has a limit — once the options are trading mostly with inherent value rather than time value, the effect will disappear.
    Still, it’s nice to own something with a net long position that goes down in price, yet still be ahead for the day.

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