Capturing volatility spikes and declines is a high risk game.  The most direct way to speculate on the direction of volatility is to go long or short a volatility instrument such as the VIX futures contracts or its exchange traded derivatives such as VXX, SVXY, XIV and TVIX.  This strategy exposes the volatility trader to very high risk for uncertain return.  Some specialized volatility instruments, such as XIV (the Exchange Traded Note which tracks the short VXX daily return), even have an “extinguishing event” clause in the fund prospectus.

This means that if the VIX skyrockets more than a predefined maximum percent move (usually 80-100% in one day), trading is halted permanently and the trader incurs a 80-100% loss in capital.   Most promoters of these instruments explain that “this scenario is very unlikely.”  Your author takes a slightly different view, namely, that “extinguishing events” happened in my trading career more than once  — in the 1974 and 1987 market crashes, after the 9/11 attacks, and during the 2008 financial crisis. Luckily for traders and promoters of these Volatility ETNs, the instruments with “extinguishing event” clauses were released in recent times, in a low volatility environment, well after all of the extreme high volatility market events in my lifetime occurred.

Moving on to safer ways to speculate, namely, long calls or puts, the trader often pays extremely high prices for naked long options, increasing the position risk and cutting into potential return.  Because of the high skew in options on VIX and VXX, vertical spreads can also be unattractive.  Often there is a very high premium for a very small potential profit.

The factors that drive up the price of verticals — options at adjacent strikes trading at almost identical prices — tend to crush the price of butterfly spreads.  The caveat is, of course, that a single cheap butterfly is often cheap for a reason.  The odds of the underlying landing at or close to the butterfly center strike at expiration are small.  This is especially true for volatility instruments, which do not exhibit “pinning” behavior the way that single stocks do, as expiration approaches and the stock gyrates around, and eventually converges at a single strike price.

Trading into a strip of butterflies — that is, buying butterfly spreads at adjacent strikes — increases the potential win zone.  During the week ending January 9, 2014, your author traded into VXX butterfly spreads at adjacent strikes at an average price of 2.5 cents per 50 cent butterfly.  At this low price, it is possible to increase the payout zone by 50 cents for every 2.5 cents invested.  In comparison, the at-the-money puts and calls in VXX were trading over 2 dollars, and the options one or two strikes out were still trading over a dollar.

Readers may notice that the strip of butterflies will create a condor spread as the long legs of one butterfly cancel out the short legs of the adjacent butterfly, and vice versa.  The advantage of using a strip of butterflies over buying a condor outright is that the sum of the individual butterflies will usually trade at a much better price than the condor, as each spread in the strip gradually gets filled as the underlying visits various price levels.

In a sharp volatility spike or decline, the butterfly strip strategy exposes traders to the risk of losing 100% of invested capital if the underlying blasts through all strikes in the strip.  For this reason, it is is important to compare the strip vs. alternatives, such as deep out of the money calls or puts, to best match the traders risk and reward preferences with the available trades in the market.

David A. Janello, PhD, CFA