Market News

June 11, 2010  Fri 9:52 AM CT

Because volatility is mean-reverting, it is appealing to sell it when the VIX spikes higher. But volatility comes in waves, and getting short volatility in the middle of a market correction is a bit like dropping your hurricane insurance with your house in the eye of the storm.

Before September 2008 it was pretty simple: If the VIX spiked above 30 you could buy the equity markets and sell volatility to make money. That is, of course, a simplification, but it is also largely true. Spikes near the 50 level had only happened a few times--and all of those from 1997 to 2002. However, the last two years have proven that markets can be more volatile than we ever expect, and selling volatility can be a dangerous game.

On May 24, at least two recommendations to sell volatility were made. IVolatility posted then that "we estimate implied volatility will decline quickly back to the 25 level." At the time, it was a relatively safe prediction that seemed highly likely to come true. They followed it up, however, with a trade idea to buy one IWM Russell 2000 June 65 call for $3.10 and sell two of the June 60 puts each for $1.68, for a net credit of $3.36.

IVolatility ChartSo they went from a highly probable outcome to a highly leveraged bet on that outcome. However, you must remember not only to look at the probable outcome, but also the consequences if you are wrong.

What if volatility continues to go up, or even goes down while the market continues to drop? That latter scenario is exactly what happened in our last crisis, as the VIX fell from 80 to 50 even as the S&P 500 continued to fall to its low below 700. The IVolatility idea isn't just a volatility trade--it is "path-dependent," meaning that it could still lose even if volatility falls.

Moreover, if the IWM did continue to fall, you would lose the debit you paid for the calls and be on the hook to buy 200 shares of the IWM at $60--no matter how far the that ETF declines. While the markets ended basically flat the next day, those who did that trade had quite a fright: The value of those 65 calls fell to $1.65 as the puts climbed to $1.95 the following morning.

So you put on a high-probability trade that took in a credit of $0.26 and then had a paper loss of $1.99 the next day. The IWM was down at $50 a year ago, and if shares fell back to that area this trade would have huge losses.

The same day of the IVolatility article, Steven Sears of Barron's recommended "A Nifty Volatility Trade" and suggested that "it's a good time to be selling calls against stock." Sears is clear in pointing out that this is a risk strategy and that "volatility is a rapier that Mr. Market uses to cut down almost everyone." The trade that Sears noted was apparently a recommendation from JP Morgan to clients to sell calls against Assurant stock. At that time AIZ was trading around $34 and the $37.50 calls could be sold for $1.55.

Those calls have quasi-protection down to $32.45. (I say "quasi" because they have that much protection only at the options expiration.) Before that they are out-of-the money calls with a fairly low delta of roughly 0.3, meaning that the change in the options price will be around $0.30 given a $1 change in the price of AIZ. So when AIZ fell to that $32.45 price level the next morning, those options didn't provide much of a cushion.

Sears suggested that this is a trade that "any neophyte options investor can try out." But the better question is whether those neophytes should try it out. If you asked them if they would sell naked puts on AIZ, I would imagine that most would say, "Of course not!" because many do not understand that the covered call and the short put are positions with identical risk profiles. (See our Education section)

Volatility selling such as covered calls can be great ways of taking advantage of declining volatility. But they should be fully understood for the risks they entail. I like to sell volatility when it gets to extremes, but I like to do it ways that don't expose me to huge losses if the storm continues to rage.

(A version of this article appeared in optionMONSTER's Open Order newsletter of May 26.)

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