SVXY Strategy: Part 2

Read part 1 **

This post discusses a path dependent model to make large returns with SVXY call options. It’s assumed you are familiar with option trading and volatility funds.

SVXY, unlike XIV, has a complete option chain going as far as Jan 2016. For the first part of this post, we will focus only on the furthest in-the-money Jan 2016 $28 call option, highlighted in yellow:

This option expires in approximately 15 months and has $5 of extrinsic value and a delta of .86.

Here’s a proxy for SVXY dating as far back as 2004 (it doesn’t go any further back). As you can see, it periodically rises and falls between 50-100%:

To double or quadruple your money you need to capture one of these upturns.

Here’s a historical chart of the VIX dating back to 1995:

As indicated by the circles and lines, there have been seven spikes above 40 and many more in the 30’s.

Putting the two charts together we see a pattern:

A VIX spike to 30 causes SVXY to fall in half.

A spike from 45-55 causes it fall in half again, a total loss of 75%.

A super-spike, such as in 2008, results in a 88% or more drop. There have only been two super-spikes in recent history, which was in 1987 and 2008. So these are very rare.

So time to create an investment strategy to capture upside from SVXY and protect, and even profit, from downside.

Let’s assume you have $50,000 in your account and SVXY has fallen 50% from it’s recent high (like it has now).

If we want to buy $18,000 worth of SVXY at a present price of $52 using the highlighted call options, you will need 4 contracts at roughly $28 each; this costs about $11,000. This is derived using: 4 (contracts) times 100 times 52 times .86 (delta)

Ok, so now you wait for SVXY to rally, as it typically does after these falls. If within the next 15 months (the duration of the option) it doubles or quadruples, you make profits of $18,000 and $36,0000, respectively. But you have to subtract $2000 (400*5) for the extrinsic value for the contracts.

What if the market crashes some more? Fist, the option will not fall as quickly as the stock; instead it will gain more extrinsic value. So if SVXY falls from $50 to $25, the $28 call may drop to $10, so you only lose $7,000 by being long four call options instead of losing $10,000 if you were long 400 shares. (to get exact numbers requires use of the Black Scholes equation)

If SVXY falls less than 50% from your buy point, ride it out. Unless the market tanks again, it will eventually go higher.

If it falls another 50% (a vix spike above 45), buy another $18,000 worth using $11,000 worth of deep-in-the-money call options, like in the previous step. So if the present price of SVXY is $52 and the peak is $93, we would be looking at a decline to $23-25 (75%). Presumably, you would be able to buy twice as many options, but the quantity doesn’t matter provided you keep the extrinsic value to around $2,000, leverage at $18000, time until expiration around 1 year, and the purchase cost to $11,000. Essentially, you’re doubling down.

Here’s a diagram of how the strategy evolves:

So even with a large market decline, within 21 months you should be able to increase your initial account size by 64%.

But what about the rest of the cash that hasn’t been deployed into options?

Let’s assume a major crisis like 2008 or 1987 and the VIX spikes above 80, in which SVXY loses 88% of its value and falls to $12 (this is keeping in mind that such events are extremely rare, having only occurred twice in a fifty year time frame). Let’s also assume that the first batch of purchased contracts expire worthless and the next phase of the crash takes 9 months, bringing SVXY to $12. The second batch of contracts you purchased are worth $3000 at this stage, bringing your account value down to $31,000. Just buy 2,000 shares or $24,000 worth of SVXY outright (no options), leaving you with $7,000 cash left over. It would not be too unreasonable to assume that within the next 6 months SVXY rebounds to $25. Your $24k becomes $48K. The $18K second batch is worth $16k (taking into account the $2,000 extrinsic value). Adding it up your account balance is $71,000. Not bad for a market crash. The reason why you buy the stock instead of options is because it’s very unlikely SVXY falls lower, but there is a possibility it won’t recover for awhile and you don’t want to deal with the possibility of options expiring worthless or losing money due to extrinsic value decay. At such depressed levels, the stock is simply a better value than the options.

Also, volatility has a nice property which is that it typically requires exponential* (second order effect) of downward movement in the stock market to make volatility rise a linear amount, similar to the Richter magnitude scale. So even if the market continues to fall, volatility may not rise anymore, which is what happened in 2009 and 2002. In the 2000-2003 bear market, for example, the VIX spiked to 40 as early as 2001 an never went above it even as the stock market kept falling for another two years. The reason why the vix didn’t spike is because the rate of decline of the market was steady. For the vix to really spike, you must have sudden, big drops. That’s why the SVXY doubling down strategy is better than a doubling down strategy with the S&P 500 because with inverse volatility funds you have the logarithmic property of volatility working to your advantage, which limits the potential losses on SVXY even as stocks keep falling. In October 2008 when the S&P 500 plunged 20% in a single week, the hypothetical backtested XIV fund made a low and didn’t go much lower despite the S&P 500 falling another 30%.

** In light of recent market events, an update on the strategy.

* Let’s assume a stock is falling linearly like y=mx+b. The first derivative is a constant, which means volatility is constant – even as the market is falling. If you have a second order decline like y=ax^2, the volatility does rise linearly