Profiting From A Drop In Volatility With VXX

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Volatility: Tonight, we’re going to go over all of the trades to kick off the last couple of days for 2014 with all of the trades that we made today on Monday, December 29th, plus we’re going to talk about the one trade that we had on Friday of last week that we just didn’t get a chance to send out a video tutorial and update for that. Here's a look at the opening and closing trade that we had.

The opening trade on Friday, the first one that we’re going to go over is RIG, and then we'll talk about our iron condor in USO and our closing iron condor for a profit in VXX. But before I do that, I wanted to point you guys in the direction of the new answer-of-all that is continuing to be updated. And we’ve posted a ton of Q&A in here, and all of these questions came exactly from emails from you all.

When I had sent out an email to all of the members about a month and a half ago, I nearly took down all the questions, and if they’re duplicates, I just took the first one down there. But, every single question that you all have asked, I've taken the time to put them all down here and make sure there are no duplicates. But everything that could have been asked in those emails is now in here and in this answer-of-all and tons and tons of questions and a lot of in-depth answers to a lot of these things.

And we’ve got probably about a quarter of the question and answers that are going to be up here posted right now, so we’ve got almost I’d say probably another 80 or so issues that we’re just continuing to put up every single day, so we’re adding probably five or six questions every single day to this new answer-of-all. And there’s no real order to them right now, and I don't want to have an order to it.

I want just to have them open flowing Q&A. But I encourage you to go over there and sort through a lot of those answers and see if there's some that maybe respond to questions that maybe you had or didn’t even know that you had, perhaps see if your question is up there that we’ve answered for you.

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Alright! Back to the trading alerts for tonight. I want to go over the one trade that we had on Friday which was our RIG iron condor. We went ahead and decided to get back into oil, and you can see we did that again today and just purely because implied volatility is high. We’ve already got oil positions for January, but we’re starting to add them out now in February because implied volatility is high. You can’t shy away from these things, and these are small positions as far as trade size.

They’re just one lot, so it's not like we’re taking in, creating this massive position in oil, but we are continuing to stay active with the number of trades that we’re doing. In the case of RIG, what we decided to do is do a February 19/23 call spread and a 19/15 put spread. You’ll notice what’s different about this iron condor is that it acts and looks much more like a butterfly spread just with wider wings.

You'll notice that both of our short strikes on this RIG position are at 19, so we sold the 19 calls and sold the 19 puts and then we went $4 out on each end and bought those options further away from the money. We sold options that were close or at the money at the time for RIG and went further out and bought those wings.

You can look at it a couple of different ways. It’s like a butterfly spread profit and loss diagram, it's definitely an iron condor still because you have two different ranges, but it also acts like a straddle with protection, so you have a straddle which is just selling two options at the same strike at the money, and then what we did is went out and bought a little bit of protection on either end which just helps reduce our margin exposure.

Because we did this very wide, we were able to take in a nice big credit of about $250 on this trade, so we’ll see where this thing goes. But ideally, we want RIG to stay somewhere in the 19 range between now and February expiration. But really, what we're looking for is just a drop in implied volatility. That's going to be the biggest thing that we’d like to see happen with RIG.

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Here’s a look at where RIG is right now, and you can see it hovering right in that 19 range which is good. We’d like to see implied volatility continue to drop from where it’s at. It’s in the 72nd percentile right now, so that’s perfect for implied volatility being that high, but we’d like to see it continue to drop probably down below the 50th percentile and that would help solidify a profit in RIG.

When we take a look at the profit and loss diagram, you can see this is what it looks like. And it sounds like a butterfly, a very wide butterfly. But RIG is trading right now right here and what we’d like to see happen is implied volatility dry up, these options decay a little bit in value, and we’re probably looking to take somewhere around $100 to $150 of profit on this trade.

We wouldn’t hold this all the way until expiration, but it is a relatively narrow trade, but I do like the risk reward. We could potentially make about $250 up at the max, the peak here and we’re risking only about $150 on this trade. Risk reward wise, it's excellent risk reward, and we’ve got a nice big window here to possibly make some money even if RIG does happen to move one direction or another.

The other trade that we got into today, Monday the 29th is our iron condor in USO. Now, this is more of your typical iron condor. We did a $2 wide spread on either end, so on the call side, we sold the 25 calls and bought the 27 calls, and on the put side, we sold the 16 puts and bought the 14 puts, all of that in total for a $.35 credit for each of those that we’ve sold.

And there’s only one of those, so we’re doing this slight, but continuing to build a lot of these trades and a lot of these occurrences in our portfolio. Now, what we did to structure this iron condor in USO is we went exactly to the 15% probability of being out of the money level for those options. If we go out here to February, you can see that where our short strike is at the time that we entered this trade today, the probability of that strike being in the money was at the 15% probability level, meaning there is about an 85% chance it wouldn’t get below or above that certain price.

And you can see that USO moved down a little bit on the day after we entered this trade, so it's a little bit more skewed towards the bearish side right now. But when we placed the trade, both of these sides were at the 15% probability level, so what that means is we add up both of the sides, we get a 30% chance of being out of those boundaries and we’re basically looking at a trade that's got about a 70% prospect of success that it lands somewhere in between these two price points or two strike prices.

A very high probability trade, that’s what we like to do. Volume and open interest were relatively good in USO today, so that was amazing. The bid-asks spread was pretty narrow. In most cases, it was a penny or two pennies wide which are great. And it just goes to show you that you should be continuing to build positions in things that are very, very liquid.

As far as closing trades today, we did have a chance to close out a trade with a nice profit, our iron condor that we had in VXX which was an unbalanced iron condor. I encourage you to go back to the video tutorial for that. I believe it was about a week and a half ago that we entered this trade. And with VXX, we decided to do an unbalanced iron condor where we had most of the risk actually to the downside.

But since we are playing volatility a little bit bearish, meaning we wanted VXX to go down, we knew that if it dropped, we’d have an opportunity like we had today to close it out at a profit before it crosses the threshold into becoming a losing trade. This one was pretty good; we liked it. We had the 35/36 call spread, and you can see that was only a $1 wide spread on the topside, and on the bottom side, we widened it out a little bit, and we have the 25/23.

This is what created the additional risk to the lower side of the strategy. And we knew that VXX would come down at some point and we knew that we’d have an opportunity to close this out before then because implied volatility would drop with VXX and the options would decay in value. VXX, if I go to the chart here, you guys would see that it did obviously continue to move down as implied volatility drops.

I believe we entered this trade maybe one or two days before the actual big drop and then you can see that implied volatility continue to decline steadily, and it’s now gone from being in the 80th and 70th percentile down into the 30th and 40th percentile, so it’s almost been cut in half which is magnificent for this position.

That's really what allowed us to make so much of the potential profit in this trade so quickly. At this point with 19 days to go till expiration, there’s no real point in holding it for another $20. We’ve made over 50% of our max potential gain. We had an opportunity today to take it off at a profit, and that's exactly what we did.

As always, I hope you guys enjoy these video tutorials. I hope everyone loves the new membership area. We’re continuing to add new stuff, so just be patient with us. But a lot of the feedback that we’re getting is that everyone likes what they see and just can’t wait for more content to be added. I appreciate all the feedback that everyone has, all the questions, all the suggestions.

I do take them to heart and try to make this thing as best as I possibly can for you guys because that's who we’re ultimately building this platform for. If you guys have any questions about this trade or any of the trades that we have, please add it right below this video tutorial. And until next time, happy trading!

About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. In 2018, Option Alpha hit the Inc. 500 list at #215 as one of the fastest growing private companies in the US. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and three children.