MX Implied Volatility Index closed on Friday at 33.89, the highest closing level in more than five years. The 30-mark when applied to index options, is typically seen as the threshold between markets that are somewhat volatile and markets that are being driven by fear.

Fear creates medium-term opportunity if you like option writing strategies. Especially with quality companies that have been hard hit, for valid short term reasons, but for reasons that are not likely to bankrupt the company. A case in point: Research in Motion (TSX: RIM).

Jumping into a company at the depth of despair is difficult, but often it produces positive results over the medium term. If you like the longer term fundamentals, and are willing to accept that, while covered call writing reduces risk, it does not eliminate it.

In the case of RIM, the company has a long history of gap trading. Looking at a one-year chart on RIM, and you will see that the stock has gapped higher three times and gapped lower twice. Usually as the company releases its quarterly earnings. More interesting, is that RIM has shown remarkable resiliency to recover from adversity. I suspect it will do so again, although with limited expectations. I am not looking for this company to set new highs any time soon.

The key with this strategy is to recognize that RIM is a great Canadian company. It is not necessarily a great Canadian stock. As one analyst suggested, the stock was priced for perfection, and as we saw last week, and in previous gaps, when it does not deliver or exceed expectations, the market reacts… quickly. Last week, taking a pound of flesh from a stock already weakened by a slowing economy.

In fact, we may see additional pain this week, which is why this trade works best over the medium term – three to six months out. But having said that, you have to believe we are closer to a bottom on RIM than to a top. Moreover, Friday’s sell off in RIM, has made the options very attractive for anyone interested in option writing strategies.

There are two ways to play RIM from here. The first is to buy shares and write covered calls. Say, buying the stock at $72.50 and writing the December 80 calls at $8.25. You could also write the December 75 calls, which depending where the stock opens, will probably trade at $9.75, when they begin trading on Monday.

If the stock is called away, the three-month return on the 75 strike call is 19.52%. The return on the 80 call is 24.51%. The return if the stock remains unchanged is 12.84% on the 80 strike and 15.54% on the 75 strike.

The other approach is writing cash secured puts. Say, writing the RIM December 70 puts, which should trade, all things being equal, around $7.00 when they open Monday. Assuming this series trades close to the 75% implied volatility number.

With this strategy, you are obligated to buy shares of RIM at $70 per share until the December expiration. Your net out-of-pocket cost for the shares, should the puts be assigned, would be $63 per share (strike price $70 less premium received $7.00 = $63.00 per share). You should be comfortable holding RIM at that price.

Index Option Strategies

On a macro level, we are likely to see some extreme volatility in the North American markets, over the next couple of weeks. Which could offer potential on both the long and short side. Here’s how.

I think it is quite likely that we will see heightened volatility over the next couple of weeks. It is not clear to me that we will see a spike should a bailout bill get through Congress. But we will likely see significant movement, first in one direction as a reaction to the initial news and then in the other direction, as the market digest the news.

In the end, we could see, over the next two weeks, a re-test of both the most recent high and low on the iShares S&P TSX 60 Index (TSX: XIU, recent low $17.75 intraday September 17, recent high $20.69 intraday August 29).

In that scenario, buying short-term straddles on the XIU could produce short-term profits. But… this strategy requires nimble trading skills and a recognition that the options are not cheap. In fact, the XIU October 19 options are trading around 50% implied volatility.

With XIU at $18.27, straddle buyers could look at the XIU Oct 19 straddle at a net cost of $1.80. On the surface, this trade makes money if XIU is above $20.80 or below $17.20 at the October expiration. But as I have suggested, this trade is about timing an entry and exit point, not holding to expiration.

Specifically, straddle buyers should lift one side based on the initial reaction to a bailout, and then the other as the market digests the news. The idea is to capture the short-term swing.

Now for the other side of the straddle. Which is to say, writing the October 19 straddle. In this case, you would write both the October 19 call and put for a net credit of $1.80. Capturing the higher than normal implied volatility currently at play.

This is also a high risk trade, because the uncovered call option subjects the position to unlimited upside risk. And it will only work, if you accept my thesis that the market will churn in a trading range over the short term, and are willing to hold the position through those gyrations.

If I am right, XIU may end up at the October expiration, around where it currently is. In which case, the straddle could be closed out at a profit. However, should the market break through the most recent high (i.e. $20.69), which is the side of the trade with the highest risk, I would cash out the position to limit losses.

Another strategy, the covered straddle, makes more sense for medium to longer term traders. In this strategy, you buy XIU at $18.27 and write the October 19 straddle against the shares. With this trade, you do not have to worry about the upside risk, because the short call is covered by your long position in XIU.

On the downside, if the market falls, you will be obligated to buy additional shares at $19 per share. But your cost of buying the second basket of shares should the Oct 19 puts be assigned is $17.20 (i.e. $19 strike less $1.80 in premium = $17.20). Your average cost for a doubling of you position in XIU shares would be $17.74 (i.e. $18.27 for initial purchase + $17.20 net cost for second block of shares = average price of $17.74) excluding commissions.

The average cost for all the XIU shares is less than the most recent low on XIU, which is not a bad scenario for medium to longer term traders.