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October 29, 2012  Mon 10:36 AM CT

VIX: SEE CHART GET CHAIN FIND STRATEGIES
The CBOE Volatility Index has climbed to its highest levels in months as equities fall and face the possibility of sliding right off the fiscal cliff. But much of the trading we have seen in the last few days has been selling volatility and playing the mean-reversion game.

Volatility selling--in its myriad forms--has frequently been the bread and butter of the hedge-fund world. It held that status going into 2008 until that strategy blew up. In the last year it seems that pops in volatility are once again seen as opportunities to get short volatility, and that is what we've seen in the last few days.

CNBC noted a big sale in VIX calls, which is certainly a direct way to short volatility. I have seen some bloggers suggest buying puts or put spreads in the iPath S&P 500 VIX Short-Term Futures ETN (VXX). And put selling is the top trade in the individual equity market as well. We noted put selling in Zynga and other names yesterday, and recently we saw big put sales in Groupon and Williams to name just a few.

Admittedly, selling "insurance" in the form of volatility when investors are clamoring for it can be very profitable. But there are many ways to do it and times when it should be avoided altogether.

Selling at-the-money VIX calls, especially when the volatility index has jumped, will most likely work out profitably. But remember that the VIX jumped up to about 80 in 2008, and if you had sold 20 strike calls you would be in a world of hurt--and potentially bankrupt. That is why some traders turn to call credit spreads or put spreads. Such spreads will have less profit potential, but also much less risk.

Put selling on individual names is another way to sell volatility. Of course, this does carry directional risk because the position can lose money even on low volatility if the stock moves steadily lower.

On the other side, however, put selling in some ways is less risky than even buying stock. If I sell puts below the market that are cash-secured, for example, the "worst" thing that can happen is that I have to buy the stock on a pullback.

In the case of the recent WMB activity, a trader sold the November 32 puts for $0.41 with the stock at $34.95. So the seller faces the possibility of buying shares if they dip below $32, but the effective buying price would be $31.59. That is certainly less risky than buying the stock for $34.95.

Moreover, the put sale would profit above $31.59, while the stock purchase would be progressively losing down to that level. The key is, of course, that the put selling can't be leveraged for the above math to work out.

Some say that the real key to volatility selling is in the timing. Doing it when the VIX spikes makes sense from the sell-high perspective. But while stocks may take a "random walk," volatility does not.

Research has shown, as has basic observation, that volatility tends to beget more volatility--and it comes in waves more than simple spikes. The trick is to ride the wave, not get crushed by it.

(A version of this article appeared in optionMONSTER's Options Academy newsletter of Oct. 24.)
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