Volatility Strategies (A) – Options on S&P

This is part of a 5-part series of various execution styles for volatility strategies - full list here.

(A) Options on S&P500 index

This is an indirect way to bet on the value of VIX, but it is in fact where VIX gets its index value from. You can't however perfectly replicate VIX. Options on the S&P gives you the ability to express a view on both volatility and on equity markets.


A1 - Tactical Long Volatility


Typically when the market has risen a great deal and fear is nowhere to be seen. The aim is to buy extrinsic value when it is low, and profit from it when it rises. Expressions can be market-neutral or bearish, since market declines and volatility increases are correlated.

The strategies below are typically not for holding till expiry, as this will negate the profits from the increase in extrinsic value (EV) - rather, at each point, assess if decaying premiums are worth the extra potential movement of underlying.

Long Straddles - market neutral strategy, will theoretically profit from any directional move, but in practice the upside only benefits from the directional move, as market climbs usually cause extrinsic values of options to drop further. If the market declines, that's when both the directional portion of the strategy and the volatility portion of the strategy will profit, giving it a double win.

Long Puts - this strategy is probably the simplest way to gain from both an increase in volatility and a market decline, which tend to go together.  In a low implied volatility (IV) environment, options are cheap, and so buying puts and losing the premium may be worthwhile. It can also serve as a protection for other parts of your portfolio where you are long equity.

Bear Diagonals - this may be held till short leg expiry. The short leg is already cheap, so there won't be much EV gain from its decay. The long leg will increase in EV but will also lose due to delta, and it's not easy to tell in advance by how much, so take the payoff model with a dash of salt. Typically the strategy is long Vega, and so coupled with the correct market direction (decline), the strategy will work. However, getting it wrong will cause you to lose more on the long leg EV than the model payoff initially calculates.


A2 - Tactical Short Volatility


Typically occurring after a market selloff, the strategies are about selling the high level of  implied volatility that is priced into the option, and collecting Theta (time decay) gains. You can also express a bullish view on the market.

Short Straddles - takes the most advantage of the high EV. The risk is that the market decline continues. An alternative is to buy Iron Condors, Butterflies, though the options on the insurance legs will also be somewhat pricey.

Short Puts - this can be a good way to enter into a market / stock at a discount (since it has sold off) and get paid for it (collecting the higher premiums for the put).

Bull Diagonals - similar to the opposite of bear diagonals above, but note that the long leg will lose more EV than calculated because a rising market tends to depress EV (cause higher Theta decay).


A3 - Strategic Long Volatility 


Is somewhat of a bear stance where you think volatility will be permanently higher. Fundamentally this requires constant market volatility which generates and sustains a higher option premium level. However, volatility cannot be sustained at a higher level indefinitely, as market calm always return once countries and investors sort the mess out (which is a normal human reaction). Therefore volatility can only be sustained at a higher level for a period of time, historically lasting around a few months (look back at the periods of Sep 2008 and Aug 2011).

The strategy is the same as the tactical long volatility ones (long straddles, long puts, bear diagonals), but using longer expiry dates and/or rolling over positions.

The main risk is that the spike in volatility may take a long time to arrive, and it may not spike as much as predicted, and thus is unable to cover the cost of all the premiums spent for the episode. Because of this, it is an incredibly difficult trade to make good in terms of risk-reward and so I advise against it. It is also psychologically draining.

A possible meta-strategy to overcome that is to increase the positions slightly for each rollover, until the spike occurs. This is somewhat like dollar-cost averaging or a Martingale betting strategy. The downrisk risk must be planned in advance, according to a reasonable runway (average number of months between spikes) and tail-end risk planning (max historical number of months between spikes) so that the meta-strategy doesn't end up losing too much and/or giving up just before a spike. Giving up just before a spike will make you want to bang your head against a wall. At least a few times.


A4 - Strategic Short Volatility 


Because of VIX's correlation with equity markets, short volatility will perform similarly to a long equity position - when market declines, a strategic (permanently) short volatility strategy will suffer as well.

The strategy is the same as the tactical short volatility ones (short straddles, short puts, bull diagonals), but using longer expiry dates and/or rolling over positions (maintaining constant exposure to short Theta).

Also possible to maintain some covered calls (or naked calls even), tweaking exposure as and when exercise occurs. The choice of shorting calls or puts will depend on your market view, current options skew, and your existing long equity positions if any.


Links to other strategies:


(A) Options on S&P
(B) VIX Futures
(C) VIX Options
(D) Volatility ETFs
(E) Options on Volatility ETF