Selling A Ratio Spread In VXX

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Ratio spread: Tonight, we’re going to go over all of the trades that we made for Wednesday, January 7th. It was a pretty active day, and we made some new trades that we’re going to talk about that we haven’t achieved in a while. In particular, we’re going to speak of a back ratio spread in VXX. And believe me, this is one of those instances where when I sent out the trade, I can just know that I had just a landslide of emails coming my way.

And sure enough, as soon as the alert went out, everyone quickly replied back to the email and had questions about it. And I tried to answer as many as I could, but hopefully, this video will help bring a lot of clarity to that particular trade because it’s not one that we make often, but it was a fascinating setup and just a different way to trade options.

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Let’s first start tonight with the closing trades. We did have a chance to close out our earnings trade in MON, so that was pretty good, another profitable trade in that stock. We actually (believe it or not) traded that stock pretty profitably. I like trading that stock, and it’s been good to us, so we’ll keep doing it every single earnings season. But we went ahead and closed it out by buying back our strangle at a $22 debit right after the market opened.

We probably could've waited a little bit towards the middle of the day or the end of the day and bought it back for a little bit less, but we never want to risk it. We’re just trying to pinpoint that drop in implied volatility which is really what we got quickly after the market opened. And the value of the options decay, that’s what we wanted, so we took a nice little profit out of that trade. With these earnings trade, all we’re looking for is just hopefully the stock not to move which MON did move.

You can see it was kind of volatile today, it had pretty big wicks, it was trading upwards of 119 and then traded all the way down to about 115, so it had a pretty good range today, but settled up about $1.5 on the day. And the more important part is that implied volatility started to drop and began to decay and that’ll just continue to accelerate I think tomorrow and the next day. That was the reason that we made the trade, and we saw that drop in implied volatility. You just got to be smart about getting out of the trade and taking your profit.

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The other trade that we got out of which I honestly didn't believe that we would get filled at a credit to get out of this trade was our broken wing butterfly in OIH. If you recall and if you want to go back through some of the video tutorials, we made a broken wing butterfly trade in OIH a couple of weeks ago, and we entered it for credit. We bought it for a credit because that’s how we do the broken wing butterflies, you'll notice it was the 36/37, we skipped over the 38 strikes and bought the 39 strikes.

Well, in closing the trade, we just reversed all of the orders that we had before, and we were able to do it for a $5 credit which is pretty incredible because ideally, these option strategies, the way that we set them up with a broken wing should not trade for more than the credit that we received. The market was trading so rich, and people were placing orders in a market so rich that we were able to close the trade with an additional credit that we really should have never gotten, so another $10 or so.

And it’s not a lot, but it is kind of interesting to see just how erratic the market got especially in OIH and some of the oil stocks today, but it gave us an excellent opportunity. The stock we thought was going to move maybe a little bit higher, but with oil moving lower, it just really solidified the position, and being able to close it for a $5 credit was pretty good and taking in a nice $50 profit.

Alright, let’s talk about VXX. And it’s just so funny because I knew that a bunch of people would be emailing me on this trade. But this is a back ratio spread, and we don’t trade these often. But it’s different than a traditional back ratio spread in that we sold a back ratio spread. And now, don't get too confused on the whole buy and sell. It’s all about the contracts that we’re dealing with. In this case, because we’ve sold a back ratio spread, what we’re doing is buying one of the 35 calls.

You’ll see that’s where this ratio comes in, this 1 to 2. This is how Thinkorswim designates it on their orders. The one right here is identified by the number of contracts that we had for the 35s, and we were long the 35 calls. The two right beside it designates that we were short two times as the next strike and that’s the 40 calls, so we were long the 35 calls, short two of the 40 calls. After all the buying and selling in between there, we ended up with a $95 credit on top of that.

We entered this trade with credit. And that's mainly why you see this sold because we have a credit on the overall trade. But let’s just look at the setup, and we’ll go through this in a lot of detail here because it's a little bit different. Here's VXX and as the market has started to fall, we’ve talked about on the strategy call with premium members that we wanted to take advantage of some implied volatility drop, whether that's with VIX or VXX.

And we’ve had success trading both of these over the past year or so. And with VXX, we said, “Let’s try these. They’re just a little bit more liquid. The pricing maybe is a little bit better than VXX right now.” We’re anticipating that this stock is going to go down, but here's what we did that’s a little bit different. And I’ll go to the trade tab here, so you can see where our position is. What we did is instead of doing just a regular credit spread or an iron condor, we decided to do something a little bit different just to mix it up and diversify across strategies.

We ended up buying the 35 calls which are close. Now, this goes against what we usually teach in that we want to sell options when implied volatility is high and we want to sell options out of the money. But we are still net sellers of options. We just did it a little bit different. We bought the 35s which were trading for somewhere around 275 or so; I think maybe 300 and what we ended up doing is then selling two more of the 40 calls above the market to help finance that purchase.

The cost of doing the 35 long calls, we then sold options further out of the money at a ratio of 1:2 to help finance that purchase. And even after selling those options, we took in an additional credit of $95. That helped and that's why we like the position so much, is we were able to do that. Now, when we go to the risk profile, this is what it looks like.

And this is I think what everyone will like about this position, is that it gives us such a good risk profile and such a good breakeven point that it makes the position very attractive. This part of the risk profile here, this is our long call at 35. I’m drawing over it here right here, so this is just what a long call profit and loss diagram looks like. It just pivots right at 35 and then continues to go higher.

And right here at 40 at the top of this little pyramid, that’s where we’ve sold twice as many call options as we bought. Now, the line goes completely back and starts to head down, and we’re naked above the market. We’re naked above the market with this trade which is a little bit different. You could add another option further out of the money or something if you needed to. But in this case, we’re naked above the market, and we’re just carrying it with margin.

But you'll notice that our breakeven point on this trade is all the way out at 46. And just because of the ratio and the width of the strikes that we’ve sold, this gives us a very, very wide breakeven. In this case, VXX or implied volatility, in general, can expand. And if it does, that gives us a bigger potential profit all the way out to 46. Let me just go back here to the chart so that you can see this. 46 is above the recent highs that we had back at the end of September, beginning of October, so that’s all the way up here.

This stock, VXX can go all the way up here to 46, and we still have an opportunity to make some money. In fact, if it goes up around 40 or so, we have an opportunity to make even more money than the credit that we took in. But the reason we like this trade, and we wanted to take in credit when doing these types of back ratio spreads is that we also have no risk at all to the downside.

You can see no matter where implied volatility goes, as long as it keeps going lower which is ideally what we want to happen, then we actually make the entire credit that we have because both of our options which are calls are going to expire out of the money and worthless if the stock continues to move lower. At that point, we’re just left with a credit that we received of $95.

A good trade, I like that trade a lot. Hopefully, that clears it up with the back ratios. I know that the alerts are a little bit confusing, but that hopefully is a great explanation of how that back ratio works. And it’s a cool trade, something that we haven’t done in a while and just fit for this situation. Alright, the other trade that we made today late towards the end of the day (and I know the alert went out late, but we got filled late) is a vertical call spread in JCPenney.

JCPenney said that they were going to announce really strong sales. The stock jumped today. It was one of the bigger ones on our watch list of liquid stock that was jumping. I think the stock was up 14%, 15%, something like that. We decided to try to take advantage of this. We’ll play a very small position in JCPenney, we’ll do a debit spread because implied volatility is low, so we’re not going to do a credit spread, we’re going to be net buyers of options here, and we did the 7/8 call spread around the stock, and we paid a $.60 debit.

Now, in this case, we spent a little bit over what we usually like to pay, but I’ll show you why it was a pretty good trade even with the stock trading at 789. Here's the chart of JCPenney and as you can see, the stock obviously had a big move higher today. And if it does continue to rally, we’re just playing it with a small position, trying to be a little bit directional and just having a little fun with options trading here. And implied volatility being low, we want to do a debit spread.

The stock right now is trading at 789. That's where it closed. That’s practically where it was trading when we entered our position. And what I like about this trade is that our breakeven point gives us a lot of room for air in this trade which is what I like. You can see here's a look at the profit and loss diagram of JCPenney and we’re making about $40 on this trade for every $60 that we put up at risk. That debit that we paid, that's the most we can lose on this trade.

But what you'll notice on this profit and loss diagram is that JCPenney is trading right about here and our breakeven point is down here at 760. This gives us just a little bit of wiggle room in the stock for not that much difference in pricing. It’s a $10 difference in pricing, but we get a lot of wiggle room for the stock to move down and still make money on this trade at expiration. That’s really why I like this trade.

But we don’t want to get too carried away and trade 50 contracts or 100 contracts. It’s still a 50-50 bet on JCPenney. We are playing this a little bit more directional, but we’re just assuming that this momentum might carry it through the next couple of trading sessions, and we might have an opportunity to close it out early for a nice little profit.

Alright! I hope you guys enjoy this video. As always, if you have any comments or questions, please add them right below, and I’ll get back to all of those tonight or tomorrow before the open. And 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.