So I’m breezing through some Dorsey Wright newsletter that found it’s way into my email, and lo and behold I see a blurb about buy-writes. They love the idea here. I don’t. Which does lead me to thinking, since among other things, they’re brilliant, and I’m not. So what am I missing?

I guess there’s just so many variables, either answer could be correct.

Let me try to ’splain.

I don’t think walking in right now and slapping on buy-writes, or their Evil Twin, naked short puts, is a bad idea. I don’t think it’s the best idea right now either, but I mean it all depends on what you are trying to accomplish. You’re locking in fat volatility sales, but the flip side is there have been a whole lot of sales that looked very fat not all that long ago. You’re also at worst, buying stock at prices even lower than these, of course that too sometimes seems dubious when the stock actually gets there.

The best way of looking at it imho is that you want to get long, but not aggressively. And despite the open-ended downside nature of they play, it’s certainly less aggressive than buying stock. The flip side of course is you don’t get the upside, but that hasn’t been an issue lately.

What IS a horrible idea though is over-writing fat calls against a stock position you’ve ridden down, or are riding down, or just own and are getting ill with. The relatively small money you took in vs. the stock will barely ease the bleeding, and will only annoy you to now end if/when it ever turns. I would way rather do the exact opposite and sell the loser stock out and replace it with calls. The premium you paid will drive you nuts when you pay it, but the plus side is you’ve now defined your downside and will still participate if it ever turns.

Anyway, going to close with a thought from Nick (Ocho Cinco) Perry over at Schaeffer’s regarding the pros and cons of premium sales in this environment.

Now, I know that one of the characteristics of volatility is that is it supposed to be mean reverting. In that scenario it seems logical to assume that volatility will decrease and therefore take option premiums with them. If that is the case, then yes, selling premium here is a potentially “easy” trade. But that is built on the premise that volatility, and the wild swings, starts to recede here.. My response to that would be - have you followed the market this week? There is nothing rational or logical going on here. Prices are swinging wildly. Maybe that lasts for a couple of days, maybe a couple of weeks.

The issue with premium selling is the you have limited upside and can be subject to some big risks. That is a fine strategy if you understand that risk and have the capital to ride through a potential blow-up. However, for most of us, I think it best to keep this quote, attributed to John Maynard Keynes, in mind…

“Markets can remain irrational longer than you can remain solvent “

So riddle me this. Short selling was still disallowed yesterday, yet financials utterly imploded. How in the world were those America Hating Evil Shorts going in there and pounding the Morgans and Goldman’s and all their friends?

Could it be, perhaps, that there are other ways to go “economically” short a stock without physically shorting it? Well, yes, we’ve gone over many of them since the Hank Doctrine came down. Could it be that some sellers were actually longs, both physically and economically? I imagine that too.

A more logical interpretation is that the rule did give pause to anyone thinking of selling the stocks for whatever reason (although merely thinking of selling the stocks was outlawed too). So in a sense a rule we mocked maybe did have the intended affect, similar to a trading halt. There was some utility to slowing it down, although I would be more inclined to have just let it play out. In fact I suspect we’d all have been better off if the PPT had just allowed more flush-outs over the course of time.

If you want my (uninformed) theory, here it is. The actual shorts maybe weren’t even economic shorts at all, rather they are hedges against CDS or CDO’s, or some other product out there that I don’t totally understand but allows unlimited and unregulated size betting on the fate of a company. If I’m standing in an options crowd and someone keeps coming in and buying puts from me by the truckload, I am going to have to keep shorting stock. Or doing a spread with someone that gets me physically long the stock that I can then turn around and sell . Am I the one “gambling” or “manipulating”? Of course not, it’s the guy buying all those puts. So compare the sizes of the markets, and it’s easy to see how a CDS panic spilled over into the shorts that Dick Fuld (and everyone else) actually abetted before becoming mortified by them

But whatever. We are here. I could argue financials both ways going forward. On one hand, sure looks like people went economically short ahead of the “real” shorts. So maybe they get whipsawed on that trade. Remember, shorts do actually get caught all the time and chase.

On the other hand, well, they sure act like wallpaper. I covered a small long gamma UYG position WAY too early, so unless it goes towards 17-18 again, I’m done.

OK, some people call me a “Maverick”. It may be because “Top Gun” was one of the first movies I ever saw with my wife.

Or maybe it was “Hot Shots”, not sure, it was a long time ago.

Anyway, here’s some Maverick-y ideas to play with this market.

Buy nearish term calls or puts, or both, and trade stock against it. Your risk is that you’re buying volatility at the highs, you’re reward is the market just won’t stop plowing around.

A little squeemish with that one? Me too, not buying much of anything in options any more. My position now is like one big OTM call, with a couple puts left as a hedge.

How about buying bullish call spreads? You don’t really risk volatility.

Well, that’s fine, but depending on the numbers involved, it’s not all that different from simply buying calls. I mean if you buy 1 call for $8 or 2 call verticals for $4, you’re really just risking the same amount of money if the stock implodes. But you’re reward is better buying calls. So it depends on the specifics, but I kind of feel like if I’m going to risk throwing away the premium on a directional move, I’d rather just keep the upside.

How about just buying stocks with stops?

Well, hasn’t exactly worked like a charm lately, but you can certainly make a case we got so unbelievably extreme it’s not a bad idea to take a shot. Cramer’s calling for a 20% decline, what better indicator can we get than that?

What about some ratio call spreads? Like buy one of a call here and short a greater number at some distant OTM price that has some real volatility pumpage too?

Kind of like this one, but again, it’s about the specifics. I do expect volatility to stay frothy until we actually rally (as opposed to us settling in here in any meaningful way), but once we rally, it’s pretty clear options have a lot of room to get pounded. Current ATM’s will hold up better in that situation, as their intrinsic value will explode. So while I like the idea in concept (especially since unlike a straight vertical, you may even structure it to take a credit in), it’s a little trickier in practice. I tried it in POT the other day for a small credit, and the stock has only gotten plowed since, so at this point I really have not accomplished anything.

So let’s look at volatility another way, the volatility of stocks themselves. It’s absolutely soaring, ahead of options themselves n fact. Bill started the ball rolling the other day, and Dr. Brett keeps up the analysis.

The chart above (on Dr. Brett’s site, please click thru) shows the S&P 500 cash index (blue line) versus its 20-day average daily true range (ATR). The 20-day ATR is a measure of actual price volatility in the index; not implied volatility as calculated by options and not premium levels built into options pricing. The ATR is the larger of the following:

* The percentage price range between today’s high and low prices;
* The percentage price range between today’s high price and yesterday’s closing price;
* The percentage price range between yesterday’s closing price and today’s low price.

What this means is that ATR captures, not only the size of the range during the trading day, but also the gaps that occur between yesterday’s close and today’s trading. It is a measure of past price volatility both within and between trading days.

The chart is showing us that actual price volatility has gone into a parabolic rise and that we recently exceeded the volatility levels from the 2002 bear market period.

What’s it all mean? Dr. Brett finds some other times when ATR got this high, and all of which are associated with long term buying opportunities. But here’s the catch. If can get stupendously worse before it gets better (like in 1987 when it got super-elevated) or simply linger and fail to resolve (like in summer of 2002; we didn’t make significant new lows after that, but we also didn’t bounce until March 2003.).

It’s also important to note that while elevated stock volatility in and of itself is ultimately bullish, it would be more bullish if in fact options got so nervous they actually trade even more elevated than stocks. And it would also be more bullish if it stopped going up.

Again, my basic strategy it so play very small, lean a little long via put vs. stock trades, and kick myself for any stock I buy.

My friend Bill brings up some very good points in the comments recently. Option volatility, most readily expressed by the VIX, is actually not high relative to actual market volatility.

The upper chart show 30 day implied vol. of the SPY in yellow, and 30 day Historical volatility in blue. And as you can see they have moved almost in lockstep.

But here’s the kicker, the IV anticipates 30 days ahead, while the HV tells you what happened 30 days behind. So in order to match up how a general option purchase did, you would have to mentally move the yellow one month, or box over to the right. In other words, let’s say you bought volatility in the form of 30 day options today. You’ll theoretically profit if the volatility of the actual market going forward 30 days is greater than the volatility you paid (pending specifics, I’m generalizing here). We don’t know how that will work out yet, but we do know with the offset that owning options at a low 20’s volatility worked stupendously well as actual realized volatility continues to climb.

Down below we show 10 day normalized historical volatility, a noisier but better measure for volatility in the here and now. And that has shot up above 60.

What’s striking is this is the mirror image to almost the entirety of 2005 and 2006. SPY volatility sat in the low teens and below, and even at those “bargain” prices, options were consistently overpriced relative to actual volatility. Which often was something like an 8 and below.

So yes, options were irrationally fearful at a 13 volatility in 2006, but not necessarily fearful enough at a 30 and even above in 2008. 48 probably another story, but time will tell

How did those VIX numbers work in September?

On September 15th, the VIX exploded about 20% and shot above 30. The SPY closed at 120.09.

On September 17th, the VIX hit new closing highs for 2008. The SPY closed at 116.61

On September 18th, the VIX shot over 42, before the PPT came in with the Bailout and later, the Shorting Ban. Perfectly timed to get the maximum Gamma Whipsaw Effect of expiration day. The SPY went as low as 115 before closing at 120.07.

Yesterday, the VIX took at the highs of September 18th. The SPY closed at 111.38.

At each juncture, it sure looked like we had hit an important, capitulatory moment. And obviously the higher the VIX gets and the lower the market gets, the closer we are to the bottom. This may very well be THE bottom. But just keep in mind this is the 4th obvious Panic bottom in the last 2 weeks. They come on TV every six minutes noting only the last  moment, but conveniently forget there was lots of pain associated with chasing the other bottoms.

OK, quick primer on the VIX.

The VIX you see on the board is a measure that has existed only since 2004. So thus when you hear it hit a “record”, it’s not as impressive as meets the high. And it was indeed a record yesterday. Bill lists the prior Top Ten closes here.

Long story short, the VIX officially began in 1993. It estimated volatility by creating a “normalized” 30 day hypothetical ATM option based on some near-money options in the OEX. In 2004, the CBOE created a “new” VIX, that substituted SPX for OEX, and included more strikes. The “old” VIX changed it’s symbol to VXO. The chart above shows VXO since it’s creation, and as you can see, it spiked into the 60’s a couple times.

But wait, that’s not the whole story either.

You can still calculate what the VIX or VXO would have been prior to 1993 by just using their methodology on old quotes. And I’m not sure if there’s an official number for the peak in the 1987 crash, but I’ve seen numbers from 150 to as high as 172 for what’s now the VXO.

So just note that truly anything can happen. Among the sillier observations I have seen is the notion that the “cash”  VIX is some arbitrary amount above the VIX futures. That number set records too (VIX futures are relatively new) and kept going.

Basically, take it as a given that we are wildly over-panicked by options measures. It will resolve at some point and in hindsight we’ll have a New Rule that will ultimately prove as meaningless as the last batch of rules. This will resolve at some point in a massive rally, just tough to say when.

Well I’m not entirely sure I can grasp the concept of how a Double Inverse Short fund has distributions to pay out. What are they collecting? My head’s spinning.

Calling Greg? Or Roger?

Anyway, be that as they pay, they paid some distributions the other day. And the options froze. Then yesterday they reopened. Looking at DUG and SDS, as best I can tell, the options on the board are adjusted to include the distribution. In other words, take SDS. The distribution was roughly $3.82 per contract. If you buy, and then ultimately exercise any of the calls on the board yesterday, you would have the right to own the stock at the strike price PLUS you get the $3.82 distribution. Likewise if you own the puts and you exercise, you owe the $4.

So clearly in order to adjust everything on the board, you need to subtract $3.82 from the strike price.

Now that’s the easy part.

These options changed their symbol from SDS to SRY. And starting today, “regular” options return, with the symbol of SDS. These regular options are just ……regular.

Same story in DUG. The distribution is $1.80. And the old DUG options are now DUD’s. No joke. The old DZG’s are now DZJ’s.

Got all that? You won’t be tested. The key takeaway’s are that option owners ahead of the news were protected via these adjustments. And the new board will look confusing, so just remember to adjust the numbers to make sense of it

OK, so long as Inverse options remain all the rage, how about a quick refresher course?

The popular Double Ultra’s and Double Inverse Ultra’s track the daily percentage move of an underlying ETF. And then reset the next morning and track it again. And so on.

But over this course of time, this math does them all in, both the longs and the shorts. It’s the same principle as if you run a fund that goes down 10%, and then back up 10%. Net-net you’ve lost 1%.

Consider some hypothetical ETF, we’ll call it IYF and its composed of a group of financial companies (let’s call them IBM and GE and GM). Let’s say it trades at 100. And we list an Ultra ETF that goes up double the daily move in IYF (we’ll call it UYG). And let’s say also we list an Evil Twin called SKF that moves twice the inverse of the move in IYF. And both UYG and SKF trade for 100.

Now on Day 1, IWF goes up 2% to 102. Assuming the fund manager tracks perfectly to design, UYG would rally to 104 and SKF would decline to 96. Now let’s say on Day 2, IYF goes back down to 100, down 1.96% on the day, but unch. over 2 days. UYG would decline double that percent, back to 99.92, while SKF would rally double the percent to 99.76.

Yada yada yada, every time the underlying ETF revisits a price, all “trackers” will have a lower NAV than they did the last time the index was there.

Is there an arb?

Eh, not really. The reason is that technically you would need to adjust your position to keep dollar neutral. Consider the real UYG and SKF, As financials declined, you needed to keep shorting more and more shares of UYG to keep flat. Plus shorting both has other risks, like the new shorting rules that may have kept SKF way above NAV without clarification.

So bottom line is that even in a world where Ben and Hank let you short things, there’s better ways to make money than this. But I would just also that this constant overhang of math makes long term ownership a poor idea. They’re really designed for swing or day trading in my humble opinion.

So let’s say you want to do something bearish, and are perplexed a bit by this maze of confusing new rules.

What about a good old married put, as jkw reminds me in the comments yesterday?

A married put involves simultaneously buying puts and stock in equal quantity. Which is a synthetic call when you place the trade, certainly a bullish play at the time.

So how is this bearish?

Well, then you go sell your long stock out. Or as much long stock out as you want. And now voila, you have created a bearish postion.

Is it legal?

Seems like it is. I mean the position was bullish when you entered it. And then last I checked you can sell stock long. So not sure I see the flaw in this unless the Federales mandate you always need a long DELTA.

The issue I suppose is that you are not allowed to actually exercise the puts when they expire. Or ever exercise them for that matter (unless you own stock). You can probably roll the puts though if the net of the roll is bullish for you. And you can also just sell the puts. Or you can take your chances the rule will be clarified or eliminated by the time October expiration rolls around.