When most folks think about trading volatility, they immediately look to VIX, VXX, UVXY, SVXY and all the exchange traded notes and funds that are not only misunderstood, but that also on occasion blow up accounts or seriously damage portfolios large and small. It’s not just retail traders that get caught in volatility storms, there are plenty of large traders that do inopportune things as well. Most of the problem stems from not doing simple homework of what the index or funds are tracking, but also following the herd, back-testing on a bias, and expecting the recent past to repeat infinitely.

But trading volatility takes many forms, and you certainly don’t need to resort to those vehicles. Just going to the source of what the volatility derivatives are based on, SPX, can give you all that you need to extract some premium from the market with a risk/return profile that is probably better than dealing in the vix futures fund space. Let’s examine a structure that is rarely if ever found in the textbooks and is a short and long volatility trade combined.

Calendar put ratio:

Short May 25th ES- E-mini S&P 500 puts at the $2680 strike

Long May 31st ES – E-min S&P 500 futures puts at $2680 strike

Ratio of short to long puts, 2-1

This is a short volatility trade, but one that can withstand a pretty nasty down day without causing major problems. The reason for this is two-fold. First, you are selling higher priced premium as measured by implied volatility in the nearer term puts. The volatility in this trade is slightly backwardated – the implied in the front is higher than in the back.  Second, rising volatility has a larger effect on longer-term puts, as they have more time to expiration. The backwardated vol can be seen in the chart below:

The volatility for this week was highest, a bit lower for May 25th, and lower for May 31st. Aiding this structure is the Memorial Day holiday.

If you look at how this trade handles rising volatility, look at this chart:

Looking a week out and stepping up the volatility by 2% from 14 to 22 (on May 23rd as shown in this chart), the profit and loss diagram looks relatively the same at all five 2% interval steps. That is the effect of owning longer dated puts, even though you are short twice as many shorter dated puts. The risk to this volatility assessment would be if backwardation were to become extreme, then the potential loss would be larger. You can’t have it all in a trade, there is going to be a way to lose. But the risk here is quite balanced relative to the return.

Doing this for trade with 4 contracts short and 2 contracts long yields an $800 credit, as the shorts were sold for $12.50 and the longs purchased for $16.50.

Because of the structure, there are several paths to victory. A. The market could go up as far as it wants, you keep the $800. B. The market goes nowhere, you keep the $800 and sell the 2 remaining puts on May 25th for what they are worth, an additional credit. C. The market goes up and then on May 25th some quantitative tightening sends the market heading down and back to the original price of 2700ish. (Some is scheduled on May 25th, how fortunate.) Implied volatility rises and you sell the remaining 2 puts for $10 or more. That would net you another $1200 on top of the $800 initial credit.

In the last scenario, you are suddenly long volatility! You can be both long vol and short vol in the same trade and do absolutely nothing until you close it out.

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