Earning double time decay with ETF options (taking advantage of ETF decay)

I had an idea while I was out running that I am just developing ATM. It has come up a few times on here that ETFs are troublesome in the long run (especially the 2x and 3x levered varieties) due to price decay. It has also been briefly discussed that shorting and ETF is one step up since now the decay is working for you rather than agaist you. However, that has it’s problems too. I believe STL mentioned he has pulled this off for limited time periods before the broker called back the shorts.

Anyway, what I had in mind was a market neutral idea similar to a classic strangle… but with a twist. I will make an example by running this strategy on the VIX.

long exposure ETF UVXY and short exposure ETF SVXY

On SVXY… write a call. By writing an OTM call on the short exposure you are getting the long side of the strangle but at the same time able to collect time decay from the short option AND take advantage of the decay of the ETF

On UVXY… write a call. By writing an OTM call on the the long exposure you are getting the short side of the strangle but at the same time … bla bla bla …as above

This is still a very raw idea and after examining the actual option chains my example, there are would be some issures in matching the exposure on the long and short side so that the set up would accuratly mimic classic strangle. I need to learn more about which funds decay the most and if the decay is constant or not. One thing was for sure… the theta on those options (especially UVXY) was sick!

I may be interested in doing something like this with ETFs on the transports (if there are long and short versions). Anything that is going to be rangebound and has long-short ETFs could be exploited with this strategy.

Two naked calls on negatively correlated ETFs? This could be ugly. A short call is not symmetrical in payoff. If the VIX really moved either way, you’d get killed on your one option but you’ll only ever have the premium on your other. What you’ve done with your proposed trade is really a short straddle/strangle. My advice here is that selling insurance on 3x levered VIX garbage in BOTH directions is going to be a very painful experience one day.

^^ oh believe me, I understand how bad a day you could have given the VIX decides to burst back up to 30+ or wallow out down at 12. I understand the nastiness of delta when you are short options. What you would have to do is write your calls way way OTM. There is actually still decent premiums to be had. Looking at the December option chain, the 125 strike is priced at about $80. Now UVXY is trading at about $38 with the VIX at 20. Even in late August this thing only went up to about $90. Given that over the last month it appears the ETF has decayed about $5 (looking at UVXY agaist the VIX)… and assuming it decays about $5 every month… what kind of obscene spike in the VIX would it take to get in trouble with a strike of 125!

… so you would go just as conservative with the SVXY side and sleep well at night knowing every day these ETFs are decaying a little more, making your short calls that much more safe.

you could also play it even safer with an iron condor type set up. ( buy an even more OTM call to protect each short)

I seem to recall modeling a beta neutral strategy to capture volatility decay via levered ETFs ; it involved shorting a 3x ETF and covering it with long unleavened ETFs. The idea was that the extra volatility drag would make the short fall faster than the long would rise and you’d get a kind of “volatility carry.” This was some years ago when the levered ETFs were fairly new.

I noticed that it was not nearly as smooth a returns stream as anticipated and had many drawdowns that I didn’t quite understand at the time but which were probably consequences of tracking error. Also it required a sizeable net cash outlay which means that there are opportunity costs.

As a result, it wasn’t a real arbitrage opportunity, but a chance to earn a return with some risk attached. But the sharpe ratio was not impressive and the conclusion was that there were a lot better risk/return opportunities around.

I suppose there might be correlation features that make this more attractive even with a low return for risk ratio, but there wasn’t really a long enough history to test that with any certainty.

I don’t know if doing this with options makes things any better. Presumably the difference in volatility is embedded in the prices already and the vol decay requires time to capture anyway. I would think that the options would expire before you got a significant return and transactions costs would eat it up as well.

^^ you bring up a good point about the opportunity cost. I was thinking I would do the same thing I always do when I have a more classic version of a strangle and it is taking up too much margin. I buy some super cheap options way out in the wings and then the only magin I am responsible for is the difference between my short and long option on each side of the strangle (basically an iron condor with the wings super far out so the price of them is negligible).

With UVXY, this is not possible. The whole chain is jacked up in price. If I was to write at strike 125, at this part of the chain the strikes start jumping $5 at a time. If I was to purchase “wings” to cut back in margin I would have to go all the way to a stike of 170 to buy something that won’t completly wipe out my $80 premium. I would be using $4,500 in margin to make $60 in a month…That’s not so great. but then again, HIGHLY unlikey I won’t earn that $60. If the VIX does go head an act up so bad that it sends UVXY to 125, it’s not going to stay there! worst case scenario is you would have to roll and wait for things to calm down … plus the ETF will decay some and that helps too.

The main point is I have constructed a method that takes the classic strangle and adds the perk of making the ETF decay work for you. If you were going to make strangles or iron condors part of a market neutral strategy anyway… might as well look into this. I have only examined one half of my example with the VIX… perhaps other pairings would work out better.

Geo’s right, you’ve just sold a strangle on the volatility of volatility. If you have a reason to think it’s expensive, then it can make sense.

Iron Condors don’t make sense imo - if the view is the OTM wings are expensive it’s counterintuitive to then buy further OTM wings. As you point out it significantly cuts into the premium of the sold strike. You can’t earn that premium without selling tail risk, that’s the point.

I understand the desire to increase return on margin, but that’s why selling tails is only a 5% strategy - if it gets levered it blows up and if the risk is capped it doesn’t earn.

^^ “selling a strangle on the volatility of volatility”… when you put it that way it sounds like an even better idea. The VIX has a reasonably predictable range that it can be sustainable at. Strangles work best when you have a predicable range for something and are still able to recieve a high enough premium for locking in at those strikes.

Originally this thread was simply about a creative strategy that sets up a strangle-like exposure with short calls on both sides in order to take advantage of ETF decay. I was looking to apply it to other long/ short ETF scenarios. I just happened to use UVXY and SVXY as an example, However, I would like to digress and examine my example of UVXY and the 125 strike.

Originally I had said that (I’ll go more conservative here) earning $50 on 4,500 in margin (per month) was not so great. Well, I have been thinking about it some more. I’m going to go ahead and say there is a near zero probability that UVXY is ever going to reach 125. I think the only reason that strike even exist is because months ago, before UVXY had that many months to decay, it was a valid stike. Now it is not. As I said, in late august the price only spiked up to $90. Given the decay of UVXY that has occured since then, even if we get another event like a 1000pt drop in the dow, UVXY would probably only go up to 80.

UVXY isn’t going to 125. Meanwhile, if you place bets every month on strikes that are no longer valid due to ETF decay, you can earn about 13% a year on essentially guaranteed premiums. I REALLY like this deal! What am I missing? I have not acually tried to sell the 125 strike… perhaps I will find there is no market for it? really, there has to be a catch here.

Are you PureAlpha?

Experience. What you’re trading here is small regular gains with massive downside exposure. You could make 1% a month, or lose 5,000% in a month. It’s highly unlikely you’ll lose that much, but it was also inconceivable that Lehman was going implode, etc, etc. People underestimate the severity and frequency of extreme events.

this has to be PAs other screename

…good point, enjoy your free moniez!

^You guys are funny!

Acually I was enjoying the conversation on one of the other threads where PA was lead to say something like… “you guys always assume I’m doing the most stupid thing imaginable”. He can say that, however, and imply that his ideas are being underestimated. Myself, on the other hand, just might do the most stupid thing imaginable! I give myself more credit than that but as Geo says… my exprience level is baloney :slight_smile:

Anyway, the very thing that make the ETF short calls attractive to me … the fund price decay… is only possible at the cost of extreme volatility which at the end of the day ends up sabotaging the practicality of the trade. I’m sure I can’t resist looking into it some more but at this point I fear I am just trying to outsmart the market maker. (note to self: become a market maker laugh)

One more thing I would like to look at though. I wonder if models exist that estimate, for example, what a certain value of UVXY at a certain time in the future would equate to in terms of the VIX. The model would account for the leverage of the ETF and the expected decay over time. I understand that it would be a rough estimate because the ETF is acually based on VIX futures and not the VIX itself. I would be curious to get an estimate as to what value the VIX really would have to hit to get UVXY to get to 125. It may not be as unlikely as I had implied. These levered funds do not go up in a linear manner, right? They start accelerating in responsivness as they get more expensive, yes? If I’m going to get into this I should know exactly what kind of bet I’m placing.

This is a good idea. I think you should focus on understanding a few things.

  1. Why does the ETF decay? It’s not strictly, or even mostly because it’s a levered ETF. This should also help you understand why the returns of the ETF are not linear.

  2. What would the price of the ETF be if the VIX doubled to 40 tomorrow. To your point, this can be a back of the envelope analysis - it will at least get you in the ballpark of understanding the types of moves that can happen.

…and at the end of the day, you can always trade it small and see how it goes.

I agree with others, you are picking up pennies in front of a freight train KMD. If the trade swings the wrong way on you margin requirements may force the position closed before you get a chance to recoup losses and you could possibly be wiped out.

Unfortunanty, this is the point. This is ALREADY trading small (only getting about 1% month). It all depends on understanding the likelihood of that 125 strike. If the VIX would literally have to go to 100 to get VIX futures wound up enough that UVXY would spike and stay there for more that a single bar, then I might go for it. I would need to know the variables of the situation very well before I decide if it is indeed an effectively “invalid strike due to fund decay”. My orignial plan (if ITM) was to count on it coming back down before expiration (which is very likely) or just rolling and being able to maneuver out of the loss. BUT, there is the problem of the margin call I’m going to get forcing me to take the loss.

I rather enjoyed being able to actually have fun and trade that flash crash on Aug 24… sure beats bawling my eyes awaiting a margin call!

i find that complex instruments like options on a 3x levered ETF are often the most efficient as the only players are pros. i bet these options are incredibly illiquid and most of your profits are eaten up by a lack of liquidity and the resulting poor price on the sale.

the question you have to ask yourself when it comes to these strategies is, “if 13% is attractive, what is unattractive?”

Haha, I swear I am not cloning myself, one is enough!

These days I’ve moved to just shorting the real CBOE futures. All the ETFs are sort of annoying in that their price isn’t tied to any scale and tracking sucks (but I do still like XIV for situations like Aug24 where you want to get short for awhile without having to roll it yourself). I looked at ETF options once but it made my head hurt.

Macro-level though, given the unstable situation and potential for explosive S&P downside I don’t want to be anywhere near volatility products right now. I guess if 30-day came back down < 15 I might go long, meh but the idea of nothing happening and contango grinding me to zero doesn’t sound fun.

I finally had the time to start carefully going over the prospectus on a few geared (levered) ETFs. These funds are fascinating . One of the main questions I wanted to answer is how predictable is the “decay” in these 2x and 3x levered funds. As the chart below shows, the decay is not constant or guaranteed. I repeat…_ geared funds DO NOT always decay! _ My idea of placing bets always counting on a certain amount of decay was flawed. Referring to my speculation on options on ETFs, there is no such thing as a “strike no longer valid due to fund decay”. Sometimes in unusual circumstances there is actually anti-decay. It is also worth noting that the short exposure ETFs experience more decay that the long version.

Interesting though, my original plan to use short calls on long and short ETFs in order to make a market neutral trade may be even stronger now. Notice that the most decay happens where the benchmark ends up going nowhere. If you want to place a market neutral trade on a benchmark that you expect to be volatile but end up going nowhere my suggested plan to write calls on both a long and short ETF should work to give you the edge from the decay of the fund as well as high premiums.

As was suggested in this thread, you would _ have _ to protect your short calls will a call spread. While waiting for anticipated decay to kick in there likely will be isolated events which cause short lived eruptions of the 3x ETF… in which case you don’t want to be prematurly kicked out of your position due to a margin call. Look at SPXU, the triple levered ETF on the S&P500. With the benchmark going nowhere over the year, the fund decayed right on que …but not without the eruptions of late summer coming first! The viability of this kind of trade comes from crafting the premium you would recieve compaired to the margin you have on the line.

After examining tables such as the one above, I get the impression that you can hijack the use of these highly geared funds to add another dimension to your trade positioning. Usually you pick bull, bear or neutral and place positions accordingly. With creative use of these funds I think you can add a postion that takes advantage of the volatility of a particual benchmark. Now you can place trades based on bull, bear, neutral or volatile.

EDIT: I was interested in running this strategy on S&P500 given I think “it will be volatile and end up going nowhere” after allowing for expected decay and using that to pick more aggressive strikes on both UPRO and SPXU, the return on the margin at risk was not as good as just making an equivalent (less aggressive strikes) trade on SPX options. yep, starting to think that you can’t really “take advantage” of geared ETF decay.

Hey so, I am reading this thread. I suggest that you do some deep reading on implied vol math, as well as variance, before attempting trades on derivatives of derivatives of derivatives of derivatives. Think about what options on UVXY really are. They are options on a rebalancing strategy on an ETF that is itself rebalancing VIX futures, which are predictions of a rebalancing scheme on two options chains, which are themselves an estimate of SPX variance. So that is like 5 layers of weird stuff.

Any statistical advantage that you see in such a trade is probably derived from something higher up the chain. For instance, implied vol trades at a premium to historical vol, and implied vol of vol trades at a further premium to realized convexity. On top of that, when you trade options on hard-to-borrow ETFs, funding is a significant price factor. The “decay” might be pricing in borrow costs; maybe that is what you want, but probably not.

Also, implicit trading costs for UVXY are high, and you can most likely save money if you trade the more liquid elemental products.

But my main point is that the basis of any good trade is understanding the risks involved, which means understanding the product, not just memorizing the 3 month time series.


Absolutly, Ohai. Trying to exploit the complexity of geared ETFs to your advantage is a can of worms… trying to exploit the geared ETF on the VIX is borderline insane. That is why I am starting on the ground floor going though the prospectus and understanding how these things work and what would cause them to have exploitable inefficiencies. That table is one of the first items presented and I got excited about it because I though I would have to derived those relationships myself. Nice of them to spell out how the decay due to compounding occures generally. Using that as a very rough estimate, I wanted to take a quick look just to see if there is even any evidence of being able to have an edge writing calls on these funds. If I do see evidence then I can feel good about the massive amount of time it will take to examine “5 layers of weird stuff”. So far I have not seen anything but perhaps I would have to come to be MUCH more sophisticated in my understanding to the point where I am playing arbitrage chicken with market makers. That would be AWESOME, but perhaps way down the road for me.

Meanwhile, options on EFTs aside, understanding the way these funds are relabalanced is a another interesting story. The “decay” for the most part arises naturally from the daily compounding. _ In addition _, there is correlation risks assoicated with the ability of the fund to properly track the benchmark with instruments they use… as well as the transaction costs, etc…For example, from the prospectus I was reading, short exposure is ONLY gained through derivatives and swaps… they don’t directly short stocks. I remember during late August I bought a few shares of a _ short exposure _ ETF that was supposed to track the Shanghai Market. The market dropped significantly overnight but the fund actaully dropped???

bottom line, the complexity of these funds interest me and I wonder if by understanding them you can gain an edge in certain looked for opportunities.

for todays Matt Levine write up