Trading VXX Options With Put Diagonal Spreads


Information about VXX, the iPath® Series B S&P 500® VIX Short-Term FuturesTM ETN, including its prospectus, can be found on Barclays’ website.

Despite the allure of buying VXX to capture a spike in the VIX futures that accompanies a market crash, the vast majority of opportunities when trading VXX can be found on the short side. One look at the long term chart of VXX shows buying it outright is a losing proposition. However, blindly shorting it or buying VXX put options without any trading rules is also unacceptably risky.

Here’s how I incorporate VXX into my trading with reasonable safety

Our community periodically trades VXX as part of what I call the Tactile Options Mini Portfolio. Tactile Options consists of several market-neutral ‘sub strategies’ we use depending on current market conditions, trends, and where we currently sit in the volatility cycle. Our VXX strategy, or volatility bias as I loosely call it, is one of them. It’s our way of safely harvesting the volatility risk premium that exists in the VIX futures market on about 81% of trading days and taking advantage of how VXX and the index it tracks are structured.

How the trade works

Volatility bias is a bearish-to-neutral play on VXX that uses a longer duration put option which is later converted into put diagonal spreads by selling short puts against the initial long put. This is also known as a Poor Man’s Covered Put:

The trade starts its life as a simple long put. Since we initialize the trade shortly after a VIX spike, we’re more bearish on VXX at the start of the trade. Early on, we don’t want to cap the potential gain which is why we start with only the long put. We don’t complete the diagonal by selling the short put until later. Details on entry signals and the setup we look for are below, so keep reading!

Hopefully, if our entry was good and the market cooperates, the initial long put will soon be profitable. This means the price of the VIX, the first and second month VIX futures and therefore VXX will have fallen. Once this period of volatility crush passes, our bias becomes more neutral. At that point, it’s reasonable to expect the pace of VXX’s decay to begin slowing, or possibly even reverse.

We now sell a short put with a closer expiry date than the long put. This completes the put diagonal spread. Turning the long put into a put diagonal spread allows us to collect some premium, offset the cost to enter the trade and therefore risk, as well as compensate for some of the theta decay experienced by the long put.

As long as VXX stays above the strike price of the short put upon expiry, we’ll receive the maximum credit for the short put. If it drops below the strike, we’ll still end up with an overall gain since the long put will always have a higher delta than the short put, which will offset the loss of the short put:

Put Diagonal Maximum Profit At Expiration = (Distance Between Long & Short Strikes) – Premium Paid, Less Any Credits

Because we’ve allowed VXX to drop so much before completing the diagonal, even if the short put becomes in-the-money, it doesn’t matter because we’ll just end up with the diagonal’s maximum profit as shown in the formula above.

The most optimal scenario occurs if VXX drops slow enough to remain just above the strike price of the short put when it expires, enabling us to sell several short puts throughout the duration of the long put, all while the long put steadily increases in value.

The time horizon of the whole trade can vary, but if we get lucky and catch a prolonged calm period for the market, the trade can theoretically be kept open for as long as several months.

The setup and trade entry

We can open a new volatility bias trade shortly after a reasonably large spike in the VIX, once we see signs the market is beginning to recover. After a significant spike, we don’t jump in right away – It’s important to wait until VIX futures “roll yield” is positive, the futures are in contango, and the S&P begins rising.

“Roll yield” is what refers to when calculating the distance between a given VIX future and the “spot VIX”, or the VIX index itself. It is expressed as a percentage and can be easily calculated:

VIX Future Roll Yield = (VIX Future Price – VIX Index) / VIX Index

Positive roll yield corresponds to a future above the spot VIX, while negative roll yield corresponds to a future below the spot VIX. Negative roll yield occurs when the VIX rises and, if roll yield remains negative, the VIX futures will continue rising up to meet the VIX. This causes VXX’s price to increase. We do not want to be directionally short VXX during negative roll yield, when it has a tailwind.

We need to wait until the VIX futures stabilize after the spike in volatility for three reasons:

  • Confirmation from the market – we want to wait for the trend to establish itself to avoid false positives as much as possible before committing.
  • Being directionally short VXX when roll yield is negative isn’t ideal because VXX still has a tailwind – it’s easier for it to rise.
  • We need to wait for implied volatility on VXX’s options to fall – entering too early after a spike means we’re paying too much for the long put. Getting the direction right isn’t enough for the trade to be efficient, we must ensure the option we’re buying isn’t too expensive.

Here’s a chart of the VIX and the second month, or “M2” VIX future to VIX roll yield. I’ve marked what I would consider good entry points, where the VIX falls after a spike and M2:VIX roll yield becomes positive again:

Where M2:VIX = the “roll yield” between the second month VIX future and the spot VIX, expressed as a percentage. Note the orange markers do not represent trade signals, or trades taken. They’re simply to illustrate points where a possible setup could exist.

Buying the long put

When it’s time to jump in, we choose a VXX put with about 120 to 180 days to expiration, depending on the expiration cycles available. We go slightly in the money, at about a -0.40 delta.

Buying an in-the-money put is preferable to an out-of-the-money put despite having a higher premium since the premium on the in-the-money put includes intrinsic value. This means its premium will be less affected by changes in implied volatility and time decay, which affect an option’s extrinsic value.

Let’s compare two options for the long put portion of the trade, on December 7, 2021, when VXX was trading at $22.90 per share. Both of these options were for the June 17, 2022 expiry which, at the time, had 192 days until expiration:

26.00 Strike Put 22.00 Strike Put
Total Premium 9.85 6.60
Intrinsic Value 3.10 0.00
Extrinsic Value 6.75 6.60
% Extrinsic 69% 100%

We would want to choose the 26.00 strike.

Since the long put serves a similar purpose as buying a LEAPS option on your favorite stock or index, we want it to be efficient by having as little extrinsic value as possible. The less extrinsic value, the less vega and theta affect it, and therefore it will behave more like a pure directional play in the underlying stock.

Ideally, we’d go further in-the-money, but the premiums of deep in the money options are high dollar value which becomes challenging to accommodate in smaller accounts. Options also tend to be more liquid when close to at-the-money.

Risk Management

Volatility Bias should always be restricted to a maximum allocation of 10% to 20% of Tactile Options capital, or whatever portion of your portfolio you’ve devoted to trading options. Shorting volatility is an inherently risky and highly leveraged trade. Since 2010, VXX has demonstrated a daily beta of -3.20 to the S&P 500. This means, on average, if the S&P drops by 1%, VXX will rise by 3.20%.

We don’t need a very big allocation size for Volatility Bias to have a big impact on a portfolio’s return. Since losses must always be kept to a minimum when trading options, we always keep things small.

The trade is managed according to both the long and any subsequent short puts. Although the long put always serves as the master stop loss meaning if we stop out on the long put, we close both legs and end the trade. Closing both means we will never have a naked short put open.

A progressive stop loss can help retain profits

The long put is managed with a progressive stop loss, meaning we adjust it upwards as the long put progresses. For example, when we first open the long put, we’ll usually start with a -10% or -15% stop loss. Once the long put is profitable, we’ll start incrementally tightening up the stop loss to +5%, +10%, etc. This means if VXX rises, we might end up just taking profits and ending the trade early.

The exit plan is the most important part

We will exit the trade whenever any of the following occurs:

#1 )The long put hits the progressive stop loss:

If VXX rises enough to hit the stop loss, we’ll end the trade early. Ideally, this happens long enough after opening that the stop loss is positive.

#2) M1 or M2 VIX futures “roll yield” becomes negative:

As mentioned above, negative roll yield is undesirable for being directionally short VXX. It also tends to only occur during periods of high risk for the market – times when we should not be shorting volatility.

#3) The long put approaches ~80 days until expiration:

All options experience time decay as they shed their extrinsic value, as measured by theta. Theta begins accelerating once an option reaches 70 – 80 days to expiration. At this point, theta starts eating away at too much of the option’s value and we will need to get rid of it.

Managing any short puts sold:

Ideally, we only begin selling short puts towards the end of volatility crush and VXX doesn’t make it low enough to hit its strike price. If it does end up in-the-money, we can either:

  • Roll the short put out and take a small loss, creating a new diagonal with the same long put.

  • Continue holding the short put until 1 -2 days before it expires, squeezing out as much theta as possible and then close both legs as a diagonal, ending the whole trade.

Which method we choose depends on how far gone the short put is. If it’s looking touch and go, we anticipate keeping the long put open or it still has enough time to expiration to accomodate the duration of another short put, we’ll probably roll it. If VXX makes a big gap down overnight and we suddenly find the short put in-the-money, we may continue holding it and accept the diagonal’s capped maximum gain.

If VXX rises a little, but not enough to hit the master stop loss, we can take profits on the short put whenever it is viable. Rinse, repeat with another short put afterward.

The first week or so after initializing long the put is the riskiest part of the entire process. Early on, the likelihood of being whipsawed out, or hitting the first of the progressive stop losses (while the stop loss is still negative) is highest. Once the trade progresses to a +5% stop loss and beyond, the trader will theoretically be able to exit with at least some profit – barring any sudden, massive move up on VXX.

Volatility ETNs like VXX, its leveraged cousin UVXY, and the inverse SVXY are exciting instruments and if managed correctly can significantly boost long term returns. But these ETNs demand respect and must be carefully traded. I like this strategy because the progressive stop loss helps us retain profits, while the short puts help offset the tail risk of being directionally short VXX.

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