Release date: 05 Aug 2020 | Eurex Group EQDerivatives - Risk Reversals and VSTOXX® Options Article by Russell Rhoads CFA, Head of Research and Consulting for EQDerivatives This article first appeared in EQDerivatives' subscription Commentary & News service. I recently had the honor of conducting a webcast for Interactive Brokers expanding on strategies to get long exposure to VSTOXX®, while minimizing the losses normally associated with long volatility strategies. During the webcast I solicited suggestions for other strategies that match this profile. One suggestion was a risk reversal. This strategy sells a put and uses the proceeds to purchase a call. On the surface it seemed like a potentially valid idea. Based on recent history (excluding market activity in March) it did not turn out as well as expected. However, exploring that strategy led me down a path to finding another strategy that holds up well in a normal volatility environment and benefits from what I like to refer to as a ‘volatility event’. First, the risk reversal was explored. Using contract data from Jan. 2018 through March 2020 I took a look at selling a VSTOXX® put with a strike price that is in line with the closing handle of the corresponding VSTOXX® future contract. This means if the future closes at 13 the 13 put is sold, if the future price is 13.50, the 13 put is also sold. The long call strike is chosen by moving up three strike prices from where a credit would be taken in for the trade. The trades would be initiated the day before the previous month’s expiration and held through expiration. Here's a quick example of the trade, on March 20, 2018 the April VSTOXX® options are traded. The April VSTOXX® future price was 17.15 therefore the VSTOXX® April 17 put is sold for 1.85 points. Then moving up the option chain to the third strike where the call premium is low enough that the trade is initiated with a credit results in purchasing the VSTOXX® April 20 call for 1.20, resulting in a credit of 0.65 points. The payoff at April expiration appears below. This trade would have resulted in a loss of 3.12 points if held through April expiration. Of course, the hope for this sort of trade is what appears on the right side of the payoff diagram, the large move to the upside, similar to the price action that occurred in March. A risk reversal following these rules would have offered up a profit of over 70 points using the March 2020 options. However, consistently following this strategy from Jan. 2018 to Feb. 2020 would result in a cumulative loss of 24.82 points. Even worse is the win percentage of about 35% (9 wins out of 26 trades). The suggestion of a risk reversal is a good one and opportunistically it can result in dramatic profits, but as a consistent strategy it is a costly method of having a position that benefits from a big VSTOXX® rally. Breaking down the numbers a bit more from the strategy above resulted in something fairly interesting. Both the short put and long call legs of the strategy resulted in losses over the 26 observations leading up to March 2020. The put leg loses 6.58 points while the long call leg loses 17.04 points. The goal behind exploring all these strategies is to find a method that keeps traders in the market, gives them long volatility exposure, and does not result in significant losses while waiting for the next volatility event to deliver a significant profit. Based on those criteria I started exploring buying a put along with buying a call. After trying a few versions of both long put and long call trades another strategy was found that historically holds up well when VSTOXX® is low, but is prepared to profit from a strong VSTOXX® rally. Again, on the day before expiration, the following months’ VSTOXX® options would be used to implement a position. Using both put and call options that have a strike price higher than the current VSTOXX® future price would be used. In order to profit from the fairly consistent drift lower in VSTOXX® futures prices two put options are purchased for each call that is purchased. Sticking with the April 2018 expiration, the following trades would occur on March 20, 2018. The VSTOXX® future was trading at 17.15 therefore two VSTOXX® April 18 puts are purchased for 2.50 each and on VSTOXX® 18 call is purchased for 1.65. The net cost of this trade is 6.65 and the payout based on the April 2018 VSTOXX® settlement price shows up below. The result here was a profit of 3.19 points per spread based on holding through expiration. The cumulative profit over the 26 expirations leading up to the volatility event in March is only 5.61 points, however, this trade is geared more toward being in a position that is ready for the next volatility event and it achieves that goal without losing capital. Also, the win rate for this approach is a bit better than the risk reversal with 13 winners and 13 losers (50%). Finally, the profit in March 2020 for this strategy comes in at a gain of 69.49. Several other strategies were tested with disappointing results, but this consistent long two put, long one call strategy worked fairly well in a low volatility environment and benefitted from a large upside move out of VSTOXX®. As noted, this work came from a question during a webcast. I’m always open to exploring ideas like this and if you have one do not hesitate to email me at rhoads@eqderivatives.com. A replay of the webinar at Interactive Brokers can be viewed here - EQDerivatives - Long Volatility Strategies Using VSTOXX® Futures and Options For more information on VSTOXX® visit here.