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As volatility remains at crisis levels, more and more retail option traders are getting sidelined by high costs. Volumes are undeniably lower, premiums are higher, and spreads are wider. Still, there are strategies option traders can use to survive the tide.

These days, it's another day, another close above 60 for the volatility index (VIX), the composite measure of implied (or anticipated) volatility in the

S&P 500

that provides the benchmark for the pricing of U.S. options. Much is made in market commentary about the relative elevation in the VIX, which is also casually regarded as the barometer of "fear" in the market. The impact on option prices is a collateral effect.

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What's in a Reading?

While the VIX provides a benchmark for the pricing of options -- contracts to buy and sell underlying stocks that were originally conceived as insurance products -- the reading is not derived directly from the Black Scholes pricing model used in the calculation of individual option contracts. Since 2003, the VIX has been derived from a real-time calculation that averages the weighted prices of out-of-the-money puts and calls on the S&P 500 index. The resulting measure provides a benchmark for anticipated volatility in the index as a whole over the next 30 calendar days.

Over the past five years, since the new calculation was introduced, the index has averaged just 17.39, having made four tests of the 50 level during periods of crisis over the preceding decade and a half (most recently after 9/11).

The index peaked out at 37 at the dawn of the credit crisis in August 2007, and this level went largely unchallenged until the collapse of

Bear Stearns

on March 17, 2008. Many observers marveled at the relative composure -- not to say complacency -- in the volatility index.

But as fears about the length and breadth of global recession have taken hold throughout the investor community, VIX volatility has spiraled higher. Since Oct. 6, the index has closed above a 50 reading every day but one (Nov. 4, when it dipped to 47.73), setting a new high just north of 80 on Oct. 27. With the volatility index staying so high for so long, options -- both call and put -- are like Manhattan real estate: expensive no matter how big they are or where you go.

Despondency and Disengagement

Conventional wisdom surrounding options maintains that buying them can protect a portfolio against exactly the kind of sturm und drang the market's been experiencing since the credit drama first began. But traditional hedging strategies -- buying calls on the VIX and index puts on the S&P 500 (SPX) -- have been caught in the crosshairs.

Over the past month, a good many traders appear "damned if they do" -- paying top premium for long calls or puts that are increasingly hard to close out profitably -- and "damned if they don't" -- leaving portfolio holdings ravaged by the effects of unrelenting intraday swings in the market and terrifying tests of new lows.

Frederic Ruffy, options strategist at, notes that overall hedging activity using options has declined since mid-October, with a steady decline in VIX call volume since mid-September. "Since mid-October, it has not paid to have been an aggressive buyer of VIX calls, and buying SPX puts has been difficult because, although the index is still falling, declining volatility and time decay will work against owning index puts," he says.

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Kevin Fischer

, head of the block trading desk at Interactive Brokers, explains it thusly: "In a time of protracted high volatility, such as what we've experienced the past two months, option traders may find that their normal trading strategies do not work, and often lose money before heading for the sidelines. This also creates a kind of no-man's land, of shrinking volumes and wider markets, where option traders don't care to be long volatility, because they know eventually it will return to historical levels, but don't want to be short either because they know it can still go higher."

To this, Ruffy adds: "Most of the investors that really wanted to be hedged are probably hedged by now. And secondly, overall sentiment has changed. While it is clear that bearishness and negativity are still very high, it is no longer panic and extreme fear - instead, the sentiment is more consistent with despondency and disengagement."

While prohibitively expensive premiums have led to a drop in hedging activity using index and nonequity instruments, there's also been a hefty impact on the cost of speculative, directional trades.

"A lot of retail traders limit their activities just to the buying of puts and calls, and that's a very scary trade to be in right now," explains Brian Overby, senior options analyst at Charlotte, N.C's TradeKing. "Even traditional directional option plays -- buying calls or puts -- have become de facto volatility plays because premiums are so high. This is especially true on the call side. If you're a long holder of calls, if the market moves up but volatility comes in, you may get crunched by a large decline in implied volatility. Implied volatility is usually negatively correlated to a market increase."

For an example of this, consider the

People's United Financial

(PBCT) - Get People's United Financial Inc. Report

, the New England-based regional thrift that replaced


(UIS) - Get Unisys Corporation Report

as an S&P 500 component on Nov. 7.

From Oct. 10 to Nov. 14, shares in People's United Financial have registered a 21% gain, compared with a 14% decline for S&P financials as a whole. That said, had an options trader looked to capture some of that upside by buying out-of-the-money calls on Oct. 10, when People's was trading at $15.16, he or she would have paid $1.46 per contract. By Nov. 14, People's shares were at $18.15, rendering those calls in the money by almost $1.

But the value of the contracts had in fact declined by 6 cents in the interim as implied volatility on People's United options came off by 16%. Positive movement in People's share price took the edge of its implied volatility, preventing a correct directional call from being closed out profitably. That, in a word, is "volatility crunch."

Puts, too, have become not just crowded but costly trades to execute in the present market environment. Holding a put on

Goldman Sachs

(GS) - Get Goldman Sachs Group Inc. (The) Report

, which has seen its share price dwindle to just about a quarter of its 52-week high, seems an obvious strategy in retrospect. Entering a new put position in Goldman today is simply too costly. And with option traders at a loss to determine without equivocation just how much is too much to pay for an option, it's little surprise to see so many traders standing at the sidelines.

Spreading the Risk

For traders looking to use options as nature intended -- namely as hedges within a portfolio of stocks -- Overby says a prevalent strategy is to use bear put spreads using index options or in large-cap index components that exhibit a high level of correlation with the broader index.

"Buying a put that's either at-the-money, or, to save a little money, 5% out-of-the-money, and pairing it with the sale of a put another 20% below that strike still gives you some downside protection and allows you to take advantage of the current implied volatility skew to puts," says Overby.

Buying bear put spreads, as opposed to buying naked or protective puts, also limits the potential profit of the transaction, because the long higher-strike put is hedged with a short, deeper out-of-the-money put on which the trader may be exercised if the underlying stock price falls below that lower strike.

And while many speculative directional or volatility plays have likewise become too costly, Overby suggests putting a directional bias on a traditionally neutral strategy, such as a butterfly, in order to express a bullish or bearish view on an underlying stock. A butterfly involves the sale of two options against the purchase of one higher strike option and one lower strike option, with the trader looking for the share price to settle at the middle strike.

"If you're really a directional player, an out-of-the-money or directional butterfly is an interesting strategy to try, because it's basically a volatility play that can express a directional view depending on where the trader places the middle strike. If the middle strike is above the current stock price it is bullish, if below make it bearish. A butterfly is especially interesting from the upside because you want volatility to come down, which will invariably happen if the market moves higher - and using a butterfly strategy instead of a naked call will keep that trader from getting crunched by volatility," he explains.

At the time of publication, Darst had no positions in the stocks mentioned.

Rebecca Engmann Darst is the Portfolio Manager for Options Alerts Portfolio newsletter and an equity options analyst for RealMoney Each Thursday at 6:30 a.m. EST, she delivers the early-morning lowdown on option volume and sector trends on CNBC's "Squawk Box." Prior to her work in the equity options market, she spent seven years in Scandinavia as a Copenhagen-based chief reporter for a European Commission news service, correspondent for Spanish daily El Mundo and Radio Netherlands, followed by stints at Nordea Bank and Saxo Bank.