I had the pleasure to talk strategy with a friend who is trading options on VIX futures. At one point, we were talking about a 'tail hedging' strategy where you devote some amount of money to holding OTM calls on VIX and how you have to be willing to lose all of that money from time decay when a thought occurred to me -- this could be a good place to do market making.

Could market making provide a source of 'positive theta' to offset the losses from owning a collection of options?

I wrote an article in 2016 about market making for junior mining holding companies and I think there are some profound similarities between options and junior mining stocks, or 'burning matchsticks' as they are sometimes referred to. For now, I will simply suggest that highly illiquid markets stand to reward the brave souls who add depth to the order book, but discretion is the better part of valour -- these markets are illiquid for a reason.

I asked my friend: Imagine that your mandate was to maintain some exposure to 4, 5, and 6 month OTM calls on VIX for next two years. You can sell the options you buy, but cannot have any net-short exposure.

We talked about it at length and came up with a few insights.

First off, a strawman argument. One way to deliver on this mandate would be to spread your capital evenly over the two year period so that you can afford to buy some options throughout entire period. This assumes you do not get anything from your prior option purchases, which may be a realistic base case.

Spreading your purchases over time in this way will satisfy your mandate, but it is not sustainable. You may get lucky and catch a spike in VIX, but you should generally expect to have nothing left at the end of two years -- largely because of negative theta from holding options. That's not much of a strategy.

Another way to meet your mandate is to roll the positions in some way. This is where it gets more interesting.

You could trade once per month to roll the risk from your 4-month expiry to your 6-month contract. That would help salvage some value from prior purchases, but you would pay a lot through the spreads in these illiquid market.

A more interesting approach would be to act as a market maker or dealer in the options.

Start by accumulating an inventory of options that you want to hold, and then post orders to buy more and sell some of the ones you own already.

There are a lot of important details that I won't get into here, but each roundtrip would provide you with some returns; each roundtrip could be seen as a source of 'positive theta' that could offset the negative theta or time decay associated with owning the options.

For example, you could place the orders just outside the best bid and offer initially and then keep them unchanged for 2 weeks. You could repeat at expiry and even generate a more complex set of 'sticky' orders based on various rules for prices and timing. You would not have much chance of getting filled on any one particular order, but you may be able to offset much of the negative theta if you are persistent.

If all went well, then you would be able to sustain some risk-exposure to VIX call options indefinitely. Imagine it -- "a zero-theta portfolio of VIX call options". With the VIX index at historically low levels and so many potential events that could drive the 'fear index' higher, I would love to figure out a strategy that could generate sustainable exposure to upside in VIX indefinitely from a single, initial allocation of capital. Stay tuned -- I will let you know if I do. From Peter Bell.