How a Hybrid Options Strategy Capitalized on Mid-February 2020 Volatility

Introduction

In early 2020, the financial markets faced a seismic shift. The COVID-19 pandemic began disrupting economies worldwide, triggering unprecedented volatility. By late February, the S&P 500 (SPY) experienced sharp declines, while the VIX soared to its highest levels since the Global Financial Crisis, peaking above 80 in March 2020. Amidst this chaos, an intelligently crafted hybrid options strategy not only weathered the storm but thrived.

This article delves into the mechanics, performance, and lessons from a hybrid options strategy that was backtested during this period. The results highlight its robustness in extreme market environments and offer valuable insights for traders aiming to navigate future volatility spikes.

The Strategy: Balancing Risk and Opportunity

The hybrid options strategy employed a carefully constructed position designed to profit from heightened volatility and potential SPY price movements:

1. Short ATM Options:

   • Sold 10 at-the-money (ATM) SPY calls and 10 ATM SPY puts to generate premium income.

2. Long OTM Options:

   • Purchased 11 out-of-the-money (OTM) SPY calls (20 delta) and 19 OTM SPY puts (20 delta).

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Key Characteristics:

• Delta-Negative: Anticipated SPY declines in a bearish market environment.

• Gamma-Positive: Captured sharp SPY price movements, ensuring profitability during rapid declines.

• Vega-Sensitive: Benefited significantly from rising implied volatility as the VIX surged.

Performance Overview

The strategy's performance highlights its ability to capitalize on volatility-driven markets:

1. Initial Gains:

   • The position began accruing moderate gains as SPY movements and minor volatility increases provided favorable gamma adjustments.

2. Exponential Profit Growth:

   • As SPY declined sharply in March and VIX surged, the long OTM options soared in value. By March 17th, the strategy achieved substantial profitability, driven by:

     • Accelerating SPY price declines.

     • Historic spikes in implied volatility.

3. Final Outcome:

   • Holding the position until expiry allowed the strategy to realize its full potential, with significant profits derived from the long OTM options far outweighing losses on the short ATM options.

Key Insights and Lessons

1. Gamma Protection:

   • The long OTM options provided critical gamma exposure, ensuring the strategy profited during sharp SPY declines.

2. Volatility Hedge:

   • The surge in VIX boosted the value of the long OTM options, offsetting losses from the short ATM positions.

3. Optimal Exit Timing:

   • While holding until expiry was profitable, exiting near peak volatility (March 17th) could have maximized returns and avoided theta decay.

4. Dynamic Adjustments:

   • Actively monitoring volatility and price levels can enhance entry and exit timing, making the strategy even more effective.

Summary

While the hybrid strategy excelled, it raises the question: how would a pure long volatility play have performed? Buying only OTM calls and puts might have achieved similar results but with higher upfront costs and greater exposure to theta decay. Future analyses should compare these approaches to assess their relative merits.

The success of this strategy underscores its potential in extreme volatility environments. By balancing premium income with tail-risk protection, it provides a robust framework for traders navigating markets with latent risks.

Disclaimer

This article is for educational purposes only and does not constitute financial advice. Options trading involves significant risk and is not suitable for all investors. Historical performance is not indicative of future results. Before implementing any strategy, consult a qualified financial advisor to assess its suitability for your financial situation and objectives.