Getting paid to hold volatility

Implied volatility, as measured by the CBOE Volatility Index (VIX), rocketed to 42 on Thursday, a five year high. And just as quickly, dropped back to 32. Same with the Mx Volatility Index that peaked at 37.49 on Wednesday and settled back to 27.29 at week’s end.

More interesting, is that since the middle of last year when the credit crisis first surfaced, volatility in the US has remained between 20 and 30, in Canada between 15 and 25, considerably higher than the average level over the previous four years.

Bottom line, volatility is still high. Which is to say, the “fear” factor is alive and well. And with short selling restrictions in play, you have to think that premiums will remain high. Given that put options are one of the few remaining ways one can bet on the downside.

The implication here is that option writing strategies are probably the best choice for the near term. Covered call writing is certainly one approach, as is the corollary to that, writing cash secured puts. Particularly on commodity companies such as gold, energy and agricultural. Or even US investment banks – i.e. Morgan Stanley or Goldman Sachs - where volatility remains especially high (I have a covered write position in Goldman Sachs). If you believe the survivors within that sector have established a bottom, then dabbling with in-the-money covered calls could yield some decent profits.

Another bailout born strategy to consider is BCE Inc (TSX: BCE). If you buy Treasury Secretary Paulson’s argument that the bailout will allow banks to get back to the business of loaning money, then the BCE deal will be a classic case study. Being a credit worthy borrower, it certainly fits the model and should go through at $42.75.

BCE closed on Friday at $37.85, which means that most traders are still on the fence. If you are willing to jump off the fence and you buy into a successful conclusion to this roller coaster deal, the return between now and the December closing is 12.9%.

On a macro basis, the option writing strategy makes even more sense. For example, you could argue that last week’s late rally had as much to do with short covering as with any real sea change in sentiment. Meaning the financial markets in general, are not likely to surge to new highs anytime soon. At least not until market participants begin to focus on fundamentals such as well… earnings, consumer spending patterns, the depth of the US recession and the long term impact the bailout will have on US government deficits.

At the moment, the only fundamental on the minds of traders is whether the US housing market will stabilize anytime soon. For the record, the answer is No! It will stabilize, but not likely until sometime next year.

On that front, the one positive with the bailout is that the US government will end up as owner of most of this bad real estate. With deep pockets, the government can presumably take a measured approach to unwinding their new found portfolio. Unless, of course, the new President decides to intervene politically, on the basis that we “must keep Americans in their homes.” In which case, all bets are off.

As for the politics of home ownership, I suspect it won’t matter who sits in the White House. It will come down to how much mileage a new President can get by trying to keep homeowners in their home… regardless of any economic consideration. Make no mistake, the overriding objective of any first term President is a second term. And we have precedent for home ownership glad handing, because it was the politics of home ownership, not economics, that got us into this mess in the first place.

And since we won’t know the political strategy until we see who the next President is, we again come back to the option writing strategy, which benefits if we see more of the same. As in a volatile environment going nowhere, but potentially, having established a near term bottom. The benefit, is getting paid to hold volatility in a trading range environment.

Longer term, covered call writing allows you to engage in a trading pattern in which you will get a fair price for your shares should the short calls be assigned. Or in the case of cash secured puts, end up averaging your way into a stock portfolio at reasonable prices, on the assignment of the puts.

I have to think that is a better approach than trying to pick a direction with so much uncertainty.