As the reality of COVID-19 sets in, many nations around the
globe are digging in for a prolonged battle against the virus. Of course, this
isn’t a traditional fight: it involves quarantines, social distancing, and
significant disruptions to our usual way of life.
Even as many companies and schools temporarily close, it’s
been business as usual for the financial markets. There has been plenty of
action in the stock market and volatility has, at times, been through the roof.
Extreme volatility often comes with daring trades. This type
of market can cause traders to make interesting and outrageous bets. Sometimes,
these types of trades end well; but many times, they can go down in costly
flames.
One such trade recently took place in options on ProShares Trust Ultra VIX Short-Term Futures ETF (UVXY). UVXY tracks a weighted balance of the first two volatility index (VIX) futures contracts that are currently trading. It uses 1.5x leverage, which means the ETF moves 150% compared to the weighted short-term VIX futures.
Most of the action in volatility (or more specifically in
VIX futures) happens in the months closest to expiration. Generally speaking,
the action occurs from the nearest-term month, at least until it gets close to
expiration, and then the activity shifts to the second-nearest month.
As such, exchange-traded products like UVXY that track
short-term futures are popular instruments for trading the VIX. Keep in mind,
the VIX itself is just an index—it isn’t tradable. And, most traders don’t want
to trade futures. Instead, ETFs and ETNs that track VIX futures are the easiest
way to trade VIX.
Back to the trade…
Some brave soul decided to sell the April 17th
165 calls in UVXY for $1.00 with the stock at $57.55. It was only 100
contracts, which means $10,000 was collected in premiums. That trader will keep
all $10,000 if UVXY remains below $165 over the next couple of weeks.
However, the loss potential is unlimited should UVXY move
above $166 (the break-even point). It’s worth noting that UVXY was at $135 just
a few weeks ago. Because it’s a levered ETF, the moves can be heavily amplified
during extreme periods.
So is this a brilliant trade and easy money, or is it crazy?
On the one hand, the chances that UVXY gets to $165 in the
next two weeks are very slim. It should
be an easy $10,000 in the bank. On the other hand, we’re in the middle of a
pandemic, and volatility has been historically high.
A trade like this is better made as a call spread, so your losses
are limited. For example, it may be possible to sell the 165-175 call spread
(selling the 165, buying the 175) for around $0.50. You are cutting your
profits in half in return for a cap on losses. During the most volatile
periods, it’s essential to manage risk as much as possible.
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