Volatility, as measured by the Chicago Board Options Exchange (CBOE) Volatility Index, had a big spike this week, rising from 24 to 34. Such action presents an opportunity to profit from the big jump in VIX trading.
XThe market is nervously awaiting the outcome of the Federal Reserve and its interest rate decision Wednesday at 2 p.m. ET. So, I'm expecting volatility might drop once the outcome is known.
Our option idea will provide a 2.4% return in VIX trading if the index stays below 40, with the chance for higher profits if the Index is trading between 40 and 50 next month.
You can track the daily move in the VIX in the Psychological Market Indicators section of Investors.com.
VIX Trading: Playing The Volatility Move
To set up this trade, we do the following:
- Buy 1 VIX July 20-expiration call with a 40 strike price @ 2.20
- Sell 2 VIX July 20 calls at 45 @ 1.60
- Buy 1 VIX July 20 call at 65 @ 0.65
The above prices were based on Tuesday's action. We pay $220 for buying the 40 strike call, receive $320 for selling the pair of 45 strike calls and pay $65 for the 65 strike call.
In options parlance, this set-up is also known as the broken-wing butterfly.
Therefore, the trade meets the criteria of being placed for a credit, with the net credit received equal to $35.
The capital at risk and maximum loss is $1,435.
Low Risk
If VIX stays below 40, all the calls expire worthless, and the trader is left with a $35 gain or around 2.4% on capital at risk.
There is a large profits zone, up to around $550 in the scenario of VIX trading 40 and 50.
However, losses can occur if VIX spikes above 40 in the first week or so of the trade, and the main risk is a VIX spike above 50.
Trading VIX options behave slightly differently from stock options, so make sure you understand how they work before risking any live capital. I would set a stop loss of 10% or around $145 for a trade like this.
Please remember that options are risky, and investors can lose 100% of their investment.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on Twitter at @OptiontradinIQ
YOU MIGHT ALSO LIKE:
With Shopify Stock Losing Its Grip, Here's A Bearish Option Trade Idea
How To Use Options To Buy BHP Stock For A Discount
How To Trade An Iron Condor On Amazon Stock
Boeing Stock Stages A Strong Bounce; This Short Straddle Could Produce $1,645
