It Don't Mean a Thing If You Can't Play That Swing

At the week's midpoint -- midday Wednesday being the top of the hump -- it's fair to say this is shaping up to be a pretty wild week. On Monday, stocks tumbled early before making an impressive recovery. But hopes that bounce would lead to a rally yesterday were quickly dashed as stocks slumped through the session. Similarly, fears that Tuesday's losses would lead to more losses today proved unfounded.

But even today's advance wasn't entirely smooth. Solid early gains faded in late morning trading, but major averages were recently on the upswing again. The

Dow Jones Industrial Average

was recently up 1.2%, the

S&P 500

higher by 0.9%, and the

Nasdaq Composite

was recently up 1.3% to 1764.39, but has traded as high as 1772 and as low as 1733.69.

But for all the volatile action there wasn't a whole lot of volatility, at least not according to the Chicago Board Options Exchange Volatility Index. The VIX measures the implied volatility of a theoretical 30-day, at-the-money S&P 100 Index option and is generally viewed as a measure of fear, or lack thereof, in the marketplace.

Despite the aforementioned swings this week, the VIX has remained relatively subdued -- continuing its recent pattern. On Monday, the index traded as high as 22.81 before closing at its intraday low of 20.74, a 2.6% decline from Friday. Yesterday, the index rose 1.5% to 21.05 after trading as high as 21.25 and as low as 20.64. Midday today, the index was down 3.9% to 20.22.

As

reported previously, the VIX is actually trading in high range, relative to its long-term trend. Options market veterans believe the index is reverting to its mean, suggesting it will ultimately settle into a range in the mid to high teens.

"What we regard now as low are still VIX

readings of 20-plus, which is an awful lot of annualized premium to swallow to buy volatility," said John Bollinger, president of BollingerBands.com in Manhattan Beach, Calif. "Even at these 'low' levels,

the VIX is relatively high."

But many market participants cannot get over visions of the late 1990s and early oughts, when the VIX traded in a range between the high 20s to high 30s and routinely, it seemed, pierced 40 and above. Those participants remain convinced a spike in the VIX is forthcoming, even if opinions vary greatly about whether the coming volatility will be of the up or down variety.

So this album's for you people, man.

(In the tradition of John Roque, a free copy of the 2002

Stock Trader's Almanac

for the first emailer to correctly, specifically identify that reference; the artist and the LP, that is.)

Gaming Volatility

What's the best way to position your portfolio if you believe volatility is going to increase, but aren't sure whether it's going to be a big spike up or a big whoosh down? Although volatility became a euphemism for a down market in the late 1990s, it really applies to sharp moves in either direction.

"If you think we're going to have some kind of violence in the market, the best way

to profit is with straddles or strangles in the options market," according to David Lerman, a former options trader and current associate director of equity index products at the Chicago Mercantile Exchange.

Say, for example, you want to bet on increased volatility in the S&P 500, which was trading around 1120 at midday: To do a straddle, you would buy an 1120 call and an 1120 put. To do a strangle, you'd buy out-of-the-money options, say an 1170 call and a 1070 put.

Ideally, the out-of-the-money options should be the same distance away from the current price so you'll get a relatively equal profit, regardless of direction. If prices fall, then the put will gain value at a higher rate than the call; the put will be closer to its strike price and presumably be of increased demand, while the call, which is already out of the money, will just be more so.

Because the options are out of the money, the cost is a little cheaper to do a strangle, but you need a bigger move to make a profit, Lerman said. In both the straddle and strangle, one side of the trade -- the call if the market tumbles and the put if it rallies -- will expire worthless, but the profit on the other side of the trade should more than offset the price of the option.

The same strategy can be employed for individual stocks and commodities, as well as market averages. For example, if you had a straddle with a 100 call and a 100 put on

IBM

(IBM) - Get Report

heading into this week, "the put would have exploded in value," after Big Blue's profit warning Monday, Lerman said.

Brokerage firms offer institutional clients products known as "volatility derivatives," which essentially mimic a straddle or strangle trade. For individual investors, the choice is whether to buy the put and call at the same time or individually, which is known as "legging the spread," Lerman explained.

Either way, he noted that such strategies entail buying two premiums -- meaning two commissions -- and investors should be careful because bid/ask spreads can be wide on some products.

"It's unlikely you will be able to hit both bids on a straddle," he said. "You have to finesse the trade."

Speaking of finesse, many thanks to

RealMoney.com

contributor Dan Fitzpatrick for his insight on these strategies and contributions to this piece.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.