I wanted to in this video do a little case study on a back ratio spread that we just did in VXX. I think it's a really interesting trade because one, we don't do it that often but two.
It gave us a really good opportunity to sell some premium as implied volatility was high and do it more on a pure play level with VXX which is very similar to VIX, but it just tracks volatility overall in the S&P.
Here on the chart you can see a graph of VXX. Usually, what tends to happen is that if VXX spikes up, we know that at some point we just have to wait long enough. Implied volatility will come back down as it always does, and we should see a good move down in VXX.
Now we don't know how high it's going to go, and that's part of the reason why we built this strategy the way that we did. I'll show you that here in a second.
In this case, we already can see that VXX is trading lower today, and we entered this spread yesterday. We're doing okay today, and we'll see if it continues to move lower. Yesterday it actually was the time that we actually entered the trade and again presented us with a pretty good opportunity to sell some premium overall.
Rather than do a regular credit spread, we just want to mix things up and do something a little bit different. What we ended up doing with VXX is we ended up doing a ratio spread, and we sold a ratio spread in particular.
A ratio spread is basically an option strategy where you're doing a ratio of trades. In this case, we did a ratio of 1:2, but you could do a ratio of 2:3 or 3:4, whatever the case is. In our case, we're just using one spread, and we did a ratio of 1:2.
What that means is that we bought one option closer to the money. In this case, it was the February 35 calls. We did buy that option closer to the money, and you can see that's where our profit loss diagram from above starts to really take off towards the top side, towards the bullish side.
We're all long options from 35 strike. Now remember, currently VXX is trading at about 30 and a half. It's trading right in here, but we're long, VXX from this point higher. Now for this option we ended up paying about $299 for just that one option, so about $300.
Now rather than wanting to outlay all of that cash in our account and pay to be long options, which we don't want to do when implied volatility is high, what we ended up doing is going back and selling two options at a higher strike price.
In this case we sold two of the February 40 calls. We sold a ratio of 1:2. We bought one, sold two. Those calls were trading at the time at $197, so about $200. We sold two of those, so took in a total of about $400 in credit.
Then that helped finance the purchase of that long option for $300. After all is said and done we took in $400 on the sale of the 40 strike calls. We bought the one 35 strike call for $300.
That leaves us with a net credit of about $100 on the trade. That's a really good example of how we can do these ratio spreads with a net credit.
This net credit is really important because as you can see on the profit loss diagram, if VXX does continue to move lower anywhere below 35, we at least stand to make that net credit.
Remember, we're trading call options out of the money. If VXX continues to move lower, these calls just expire worthless on both ends, and we keep the credit that we received in the initial trade.
Now when you look at the profit-loss diagram, again you can see that we are along the VXX from 35, but then it pivots again right at the top here at 40. That's where we sold those two options. Right here at the 40 strike, it pivots and starts moving back at the same pace that it rallied up higher.
Now we are net naked on this trade above that strike. We did have to cover a little bit of margin requirement on this trade, but as you can see on the graph here what's really good about this trade is that our break even point on this trade is all the way up here at 46.
It gives us a really wide range for VXX to move higher. Even though we're selling naked calls, and I know people think it's really risky to do that, but in this case we know how much risk we're taking with margin.
It gives an opportunity actually to profit if implied volatility in fact does go higher from here. That's why we like the trade. We can profit if implied volatility contracts or goes down, which is ideally what we want to happen.
If implied volatility does start to rally up higher, then it might rally right into our range up here where the ratio spread peaks out around 40. That gives us a great opportunity to actually create a little bit more of a profit in this trade as implied volatility rises higher.
Again, if we go back to the chart here, you can see that our break even point is all the way up at 46. Let me just actually shrink down this chart here, and you can hear trades going off in the background.
Our break even point is all the way up here at 46 just barely on the chart up at the top. This is our big range. We can allow VXX to go all the way up here to 46, and we still make money on this trade, or it can go down, and we still receive the credit that we took in on the initial entry.
You can see it's a very wide, highly profitable trade. Now if VXX starts to trade inside of this 40 range and implied volatility expands, which it very well could. Today it hasn't, but it very well could do that.
Then we actually might see a little bit bigger profit. That's why we targeted that $40 range because that's where it's moved before in the past. If it does move up towards that range, we want to have some options there that we can make some money on.
That's the trade in VXX. Now here's what's really cool about this trade, and hopefully that makes sense setting it up. It's a really interesting strategy. You can see the profit-loss diagram. It's something different than what we typically do.
Now here's what's really cool about this trade. As VXX is continuing to move lower, one of the things that we can do is go ahead and buy protection right in front of our break even point. I'm going to add a simulated trade here at 45.
Now the reason why I added it at 45 is because you'll remember our break even point currently is 46. If I add protection and buy a long option at 45, then I'm adding protection and buying options ahead of my break even.
Theoretically, I should have no risk on this trade at all so long as the cost of this option which is currently $83 is less than how much I took in on the initial credit. Now you'll remember the initial credit on this trade was $100.
We took in about $100 on this trade. If I can spend some of that $100 to buy protection for this trade, then I will create a trade that has absolutely no risk and 100% upside potential, if implied volatility rises.
In this case, the $100 credit. Then we use some of that money that we have left over to buy protection for it for $83, and we still have a little bit of money left over. Here's what the profit-loss diagram would look like, if we enter this trade to buy protection.
You can see at no point on our profit-loss diagram are we losing money. Everything on this profit-loss diagram is above the zero barrier. It's just that we have a risk-free trade on, and it only took us a day to get this trade on and a little bit of help from the market movement.
In this case, this risk-free trade is no longer using up any capital because we have no capital requirement. There's at no point at which on this chart we lose money. VXX can trade anywhere it wants.
Basically, what we're doing here is we got a free lottery ticket to see if implied volatility goes higher. We have an opportunity to bank a really, really big profit on this trade, so a really cool trade.
That's the setup, and that's why I wanted to go through this case study today. Again, it's a day after we enter the trade. This is the adjustment that we're looking to make.
You can see how customizable options trading can be, and you just use strategies in the market movement to help create positions that give you a ton of upside gain with absolutely no risk.
As always, if you have any questions about this trade that we did, please ask them right below in the comments section on this lesson page. Until next time, happy trading.