Traditional covered call writing involves first buying a stock (or exchange-traded fund) and then selling a corresponding call option. The result of the initial trade is to generate cash flow from the option sale and lower our cost basis on the stock side. Based on member feedback, there has been a growing interest in writing covered calls on the VIX (CBOE Volatility Index). The VIX is a measure of expected price fluctuations in the S&P 500 Index options over the next 30 days. It is also often referred to as the investor fear index. Although there are VIX options, there is no VIX stock per se. This article will highlight the ways of using VIX with covered call writing and also explain why this strategy is generally not a winning idea for most investors.
What is VXXB (formerly VXX)?
This is an ETN or exchange-traded note (like a stock) that is based on a portfolio of the nearest 2 VIX futures contracts. A “stock” is created based on these futures contracts. Each day, the fund sells the near-month contract and buys the back-month contract to meet its daily goal requirement.
How to create a VIX underlying for covered call writing
- Buy 1 VIX Future contract and sell 10 VIX calls against it
- Buy 100 VXXB shares and sell 1 VXXB call option
- Synthetic covered call in VIX using 3 option positions
Since this site does not deal with futures contracts, we will focus in on the latter two.
VIX covered calls using VXXB
The nature of the VXXB product is not in our best interest. There is a negative strain on the price of VXXB because the sale of the near-month futures contract in conjunction with the purchase of the back month contract usually results in a net debit…we are riding our bicycles uphill! The back month is priced higher than the front month (called being in contango) 88% of the time. Add in ETN fees along with the cost to roll the contracts daily makes this product almost impossible to become an income-generator. Here is a screenshot showing futures in a contango relationship:
When there is a spike in VIX, the curve may invert resulting in a phenomenon known as backwardation. The two are compared in the screenshot below:
Synthetic long covered call
To create a synthetic long stock position, we can buy an at-the-money (ATM) call and sell an ATM put. Since a stock has a Delta of “1” we can create the equation from a Delta perspective:
[+.5 (long call) + (-) – .5 (short put)] = +1 (same as long stock position)
Against this synthetic long stock position, we can now sell the covered call. Here’s what it would look like graphically:
This approach has the advantage of using the actual VIX and not futures contracts as the underlying although we are now dealing with 3 legs to the trade.
We have thousands of underlyings to select from with covered call writing. An investor must ask herself why should a futures contract, an ETN with a negative drag on price or a third leg to the trade be introduced? Volatility products are complicated and difficult to understand, even for professionals. Retail investors should be cautious before risking our hard-earned money with volatility products.
March 8th stock report
*** PLEASE NOTE: The stock report for the week ending March 8th will be published on Monday March 11th, later than usual due to vacation and travel plans. Every effort will be made to post this report as early as possible.
Quinnipiac GAME Forum
International forum for college and graduate school finance majors
Alan will be hosting a free webinar for the Options Industry Council (OIC) on generating income from selling options. More information to follow.
All Stars of Options
Bally’s Hotel, Las Vegas
10 AM – 10:45 AM
How to Select the Best Options in Bull and Bear Markets
Las Vegas Money Show
Bally’s/ Paris Hotel
12:15 – 3:15
This is a paid event hosted by The Money Show
Your generous testimonials
Over the years, the BCI community has been incredibly gracious by sending our BCI team email testimonials sharing stories as to what our educational content has meant to their families. Moving forward, we have decided to share some of these testimonials in our blog articles. We will never use a last name unless given permission:
Just another thank you on your books. I have read all 5 of them. I was very surprised on the ease of read and how well you put them together. I have read over 500 books and I found you to be the easiest read of any Author, so I congratulate you on finding your talent of writing.
This week’s economic news of importance:
- Chicago Fed national activity index Jan. -0.43 (0.05 last)
- Wholesale inventories Dec. 1.1% (0.4% last)
- Housing starts Dec. 1.078 million (1.256 million expected)
- Building permits Dec. 1.326 million (1.322 million last)
- Case-Shiller home price index Dec. 4.7% (5.1% last)
- Consumer confidence index Feb. 131.4 (124.7 expected)
- Advance trade in goods Dec. -$79.5 billion (-$73.5billion expected)
- Pending home sales index Jan. 4.6% (-2.3% last)
- Factory orders Dec. 0.1% (0.5% expected)
- Weekly jobless claims 2/23 225,000 (as expected)
- GDP Q4 2.6% (1.9% expected)
- Chicago PMI Feb. 64.7 (56.7 last)
- Personal income Jan. -0.1% (0.3% expected
- Consumer spending Dec. -0.5% (-0.4% expected)
- Core inflation Dec. 0.2% (as expected)
- Markit manufacturing PMI Feb. 53.0 (53.7 last)
- ISM manufacturing index Feb. 54.2 (55.5 expected)
- Consumer sentiment index Feb. 93.8 (95.6 expected)
THE WEEK AHEAD
Mon March 4th
- Construction spending Dec.
Tue March 5th
- Markit services PMI Feb.
- New home sales Dec.
- ISM nonmanufacturing index Feb.
- Federal budget Jan.
Wed March 6th
- ADP employment Feb.
- Trade balance Dec.
- Factory orders Jan.
- Beige book
Thu March 7th
- Weekly jobless claims 3/2
- Productivity Q4
- Trade balance Jan.
- Consumer credit Jan.
Fri March 8th
- Nonfarm payrolls Feb.
- Unemployment rate Feb.
- Average hourly earnings Feb.
- Wholesale inventories Jan.
For the week, the S&P 500 moved up 0.39% for a year-to-date return of 11.84%
IBD: Market in confirmed uptrend
GMI: 6/6- Bullish signal since market close of January 31, 2019
BCI: I am continuing to favor out-of-the-money strikes 2-to-1 compared to in-the-money strikes.
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a greatly improving market tone. In the past six months, the S&P 500 down 3% while the VIX (13.57) moved up by 3%.
Wishing you the best in investing,
Alan and the BCI team