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Get Paid to Own Volatility

Get Paid to Own Volatility

Jeffrey Gundlach may be unique among investment managers. This is an industry known for conservative behavior and managers are generally profiled in relatively boring articles. Boring is not a word that comes to mind when thinking about Gundlach.

He may be the only investment manager who has publicly talked about the fact that his personal security guards are authorized to shoot to kill. He recently told the Buffalo News:

“If somebody’s interested in causing me trouble, they already know that it’s going to take a number of people. Some of them will die.”

Gundlach was profiled in the Buffalo paper because he has donated more than $42 million to a local art museum. He has achieved his wealth by being a great investment manager, and he knows he is great as he told the News:

“I’m in the fixed income hall of fame. I’ve got the most successful startup investment management company in the history of the business. I don’t have anything to prove. To people who like to criticize me, I say: So, what major museum is named after you?”

Style, Performance and Free Money

As those quotes show, Gundlach is a character. But, the investment business is built on performance and investors focus on results rather than interesting quotes. Gundlach also delivers on this front.

His largest fund, the $53 billion DoubleLine Total Return Bond Fund has delivered an average annual return of 6.6% return since inception, outperforming its benchmark by 78%.

Now, Gundlach is looking at a trade he describes as “free money.” From any other investment manager, a claim like that might seem like hyperbole. But, Gundlach gave specific reasoning to support his idea.

News reports indicated his fund purchased put options on the Standard & Poor’s 500 Index as the CBOE Volatility Index, or VIX, fell to its lowest since December 1993. Gundlach recently told Reuters about his trade idea for free money.

“We lost money the first day we put on the trade, but now we are doing great. This is like free money. We are in a seasonally weak period for stocks, but more importantly, we think the VIX was really, really low. So the S&P puts are going long volatility.”

He added, “Now we wished we had done more.” The put options on the S&P 500 translate into “going long volatility. The price is ridiculously low” on VIX, according to Gundlach.

Finding a Trade to Ride Alongside Gundlach

Gundlach chose to trade volatility indirectly, with a put option on the S&P 500. This is one strategy but he has significant access to capital. Overall, Gundlach is managing about $110 billion in assets. Individual investors without access to significant amounts of capital may want to consider an alternative strategy.

It is possible to trade volatility with Exchange Traded Notes (ETNs). An ETN is similar to an ETF. It can be bought and sold just like a stock and has low trading costs. The difference between the two is that an ETF owns stocks while an ETN owns derivatives, adding another level of risk to the investment.

A derivative is a trading instrument that is based on something else. It will always have an expiration date. On that date, the contract will spell out settlement terms. An option on a stock is an example of a derivative. At expiration, the settlement calls for delivery of stock if the option is above or below a certain price. Otherwise, the contract is worthless.

Options are traded through an exchange and are backed by the rules of the exchange. There is no risk that one party in the trade will fail to meet the settlement terms because the exchange rules ensure everyone with an open trade can meet their obligation.

Not all derivatives are traded on an exchange. Many contracts are customized and the settlement terms are individualized. The parties to the contract set the terms and collateral requirements. There is no exchange in the middle to enforce the settlement terms. This creates a risk of default.

Default risk can be found in some ETNs. These products use customized derivatives and are usually contracts between the ETN and a major investment bank. Technically, there is a risk of default although in the bear market of 2008 and 2009, there were no defaults in any exchange traded products.

While this risk is remote, it should not be ignored. When trading ETNs, conservative investors should consider the underlying derivatives owned by the ETN. A visit to the ETN sponsor’s web site will usually provide this information.

An ETN Can Be Used to Trade Volatility

For trading volatility, there are a number of ETNs available. One of the most liquid ETNs is iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). This ETN has assets of more than $1 billion and a relatively deep market for options.

VXX is based on VIX but does not strictly track the VIX index. Its underlying holdings consist of futures contracts on the VIX. These are exchange trade futures and are therefore as free from default risk as possible for a derivative. That makes VXX an ideal choice for conservative investors seeking a volatility trade.

While the underlying assets are free from default risk, this is not a conservative investment. VXX is a risky investment and the ETN shows a long term downward bias. The ETN frequently completes a reverse split to maintain a price above $10 a share.

As the chart shows, VXX tends to spike higher at times. That creates a potential trading strategy. It is possible to buy the ETN. That sets up a possible profit if the trader can sell for a gain when the spike occurs. The consistent downward bias makes that difficult to do in practice.

A Specific Trading Strategy

To overcome the downward bias, a trader can use an options strategy to create a synthetic long position.

The synthetic long strategy combines two option positions, a long a call option and a short put option. Both have the same exercise price and expiration date.

This combination of options simulates the risk and reward profile of being long a stock. Being long a stock means owning it outright. This is shown in the figure below.

Source: The Options Industry Council

The principal differences between a synthetic long strategy and owning a stock are the fact that it costs less money to open the open position; the time limitation imposed by the term of the options; and the absence of a stock owner’s rights to vote on corporate matters and collect dividends. These rights are irrelevant in the case of VXX.

Many analysts believe VIX is likely to spike before the end of the year. This means we could use options on VXX that expire in December to catch that move. Specifically, with VXX trading near $12, the following options could be used to create a synthetic long position:

  • Buy December 15 $12 call on VXX for about $1.98
  • Sell a December 15 $12 put on VXX for about $2.18

This trade will result in a credit of about $0.20, or $20 per contract since each contract covers 100 shares. That may seem small but you are in effect being paid to obtain exposure to VXX. If VIX spikes and VXX moves higher, this position could be closed at a profit.

If VIX fails to spike and VXX declines, this trade could lead to a large loss. If VXX falls to $8, for example, the $12 put would be worth $4 and the loss would be $3.80. The maximum theoretical loss on the trade is $11.80 per contract. For that reason, a stop loss should be considered.

Covering the put if VXX moves below $10, for example, could limit the potential loss while allowing for a large potential profit if VIX rises as expected, providing “free money” in the words of Jeffrey Gundlach.