The VIX Strategies that we trade are systematic in nature (with the exception that Roll-Yield + VRP uses discretion from time-to-time).  This does not mean, however, that we don’t like to take advantage of special opportunities when they arise, on a discretionary basis.  Often, these opportunities are centered around drawdowns in SVXY / XIV (usually after large spikes in volatility).  One discretionary method we’ve discussed in the past is selling OTM put options to get paid to scale into drawdowns of SVXY.

 

You can read more about this approach in our previous post here: When is the Best Time to Start Trading a Volatility Strategy?

 

Today, we’re going to add another tool to our discretionary arsenal – risk-reversals.

 

Risk-Reversals

A risk reversal is an option strategy that sells an OTM put to purchase an OTM call of the same expiration (this is a bullish risk-reversal).  Risk-reversals can be put on for a credit (the option that is sold is more expensive than the option that is purchased), a debit (the option that is purchased is more expensive than the option that is sold), or zero cost (the option that is sold is the same price as the option that is purchased).

Risk-reversals can be a good tool to take advantage of drawdowns in SVXY because:

  • You gain positive delta (long the underlying) while having a buffer to the downside

    • The buffer to the downside comes from the fact that the option you sold is OTM.  The size of the buffer is the distance between the strike of the short put and the current price of SVXY, plus the net credit/debit between the put and call.
  • Vega (sensitivity to volatility) and Theta (time decay) are minimized

    • This comes from the fact that you are long one option and short another, largely offsetting vega and theta, while maintaining delta.  This can be especially important after drawdowns in SVXY as the price of options can become relatively expensive (due to increased volatility), making the standalone purchase of a call option cost prohibitive.  More simply, the cost of the long call is financed by selling the short put.
  • Upside potential is high (relative to the short put method outlined previously).

    • The high upside potential comes from the purchase of the OTM call.
  • There is flexibility in how you manage the position

    • You can close, roll, get assigned, etc.
  • If you’re willing to get assigned on the short put, you can effectively scale into drawdowns of SVXY (in the same manner as the short put method outlined previously, but with higher upside potential)

Let’s walk through some examples of using risk-reversals after drawdowns in SVXY.  For consistency, we’ll use the same examples as in our previous post.  Please note that these examples are meant to serve as a basic introduction.

 

Example: 1

Date: 6/24/2016

Event: Day after Brexit Vote

SVXY Drawdown: 35% from recent high on 6/7/2016

SVXY Price: $43.13

Position: Sell 1 of the 7/1 38 strike puts for $2.00; Buy 1 of the 7/1 44 calls for $1.87

Thesis: the recent selloff is over-blown and we want to take advantage of a possible rebound; if we’re wrong, we’re willing to get assigned 100 shares at $37.87

Time of Entry: 3:55pm ET

 

SVXY Price Graph 6/24/2016

 

Risk-Reversal Payoff Profile

We’re effectively long 73 shares of SVXY (delta of 73), with a 12% buffer to the downside before we start losing money (at expiration).  We’ve isolated delta, while minimizing vega and theta (in this example, theta is actually slightly positive due to the long call being less costly than the short put).  We have high upside potential, with a cushion to the downside if the position moves against us.  To look at it another way, assuming we’re willing to get assigned on the short put, we’ve effectively committed ourselves to getting long SVXY at $37.87 ($38 strike – $0.13 net premium), or 12.2% lower than the current price, and nearly 43% lower than the recent high, if SVXY trades below $38 at expiration.

 

SVXY Price Graph 7/1/2016

 

Risk-Reversal Payoff Profile (at expiration)

On 7/1/2016 (date of options expiration), SVXY traded at $50.59.  Our thesis was right and we earned 112% on our capital.

 

Example: 2

Date: 10/28/2016

Event: Upcoming US Presidential Election

SVXY Drawdown: 10% from recent high on 10/24/2016

SVXY Price: $73.45

Position: Sell 1 of the 11/4 68 strike puts for $0.85; Buy 1 of the 11/4 78 calls for $0.70

Thesis: the recent selloff is over-blown and we want to take advantage of a possible rebound; if we’re wrong, we’re willing to get assigned 100 shares at $67.85

Time of Entry: 3:55pm ET

 

SVXY Price Graph 10/28/2016

 

Risk-Reversal Payoff Profile

We’re effectively long 43 shares of SVXY (delta of 43), with a 8% buffer to the downside before we start losing money (at expiration).  We’ve isolated delta, while minimizing vega and theta.  We have high upside potential, with a cushion to the downside if the position moves against us.  To look at it another way, assuming we’re willing to get assigned on the short put, we’ve effectively committing ourselves to getting long SVXY at $67.85 ($68 strike – $0.15 net premium), or 8% lower than the current price, and nearly 17% lower than the recent high, if SVXY trades below $68 at expiration.

 

SVXY Price Graph 11/4/2016

 

Risk-Reversal Payoff Profile (at expiration)

On 11/4/2016 (date of options expiration), SVXY traded at $64.35.  We’re down 25% on our capital.  We have three main options:

  • Accept our loss and move on

  • Get assigned 100 shares of SVXY at an effective price of $67.85 (effectively getting long SVXY during a drawdown)

  • Roll the risk-reversal to the next expiration

For the sake of continuing our example, we’ll roll the risk-reversal to the next expiration:

 

Example: 3

Date: 11/4/2016

Event: Rolling Risk-Reversal from Example 2

SVXY Drawdown: 21% from recent high on 10/24/2016

SVXY Price: $64.35

Position: Sell 1 of the 11/11 56 strike puts for $1.87; Buy 1 of the 11/11 72.5 calls for $1.87

Thesis: the recent selloff is over-blown and we want to take advantage of a possible rebound; if we’re wrong, we’re willing to get assigned 100 shares at $59.43

Time of Entry: 3:55pm ET

 

Risk-Reversal Payoff Profile

We’re effectively long 50 shares of SVXY (delta of 50), with a 13% buffer to the downside before we start losing additional money (at expiration).  Our break-even point (on the total position, including the first risk-reversal) is $75.94 (at expiration).   We’ve isolated delta, while minimizing vega and theta.  To look at it another way, assuming we’re willing to get assigned on the short put, we’re effectively committing ourselves to getting long SVXY at $59.43 ($56 strike – $343 loss on first risk-reversal), or 8% lower than the current price, and nearly 27% lower than the recent high, if SVXY trades below $56 at expiration.

 

SVXY Price Graph 11/11/2016

 

Risk-Reversal Payoff Profile (at expiration)

 

On 11/11/2016 (date of options expiration), SVXY traded at $75.75.  We’re able to exit our position for a small loss of 5% (on total capital from both risk-reversals).

 

Final Thoughts

Risk-reversals are a great tool to have in your discretionary arsenal.  They provide delta (allowing you to get long SVXY during a drawdown), while minimizing vega and theta, and provide a buffer to the downside.  Further, there is flexibility in how you manage the position.  Finally, if you’re willing to get assigned, you can use them in a similar fashion to the short put method – effectively scaling into drawdowns of SVXY.