Over the past several weeks, many market-moving events -- heavy mutual fund redemptions, the Fed's weak view of the economy and the Aug. 14 certification deadline -- have had an impact on volatility. The ease with which the Chicago Board Options Exchange Volatility Index, or VIX, has been gyrating up and down this summer is unprecedented. Wild market swings have caused the VIX to move at least 30% four times over the past 45 days.

The Aug. 14 certification deadline, when CEOs were required to attest to their financial statements, was met with only a handful of revisions, and that seems to have alleviated some of the market's uncertainty. Investors feel relieved because they don't own the next potential disaster. The compression that was keeping stock prices down has been released, and investors have been subsequently moving back into the market.

The Long and Short of It

Shorter-term implied volatilities frequently trade at higher levels than longer-term implied volatilities. This is because over time, option volatility tends to revert to the mean, but in the short term, option-volatility swings are often less predictable.

October volatilities are equal to or, in some cases, higher than September volatilities. At first glance, this would seem to be an excellent opportunity for the arbitragers to sell calendar spreads, buying September calls and selling October calls.

However, just as the high premiums in August were justified by many market-moving events, September seems devoid of important dates. October premiums are high because earnings season, the next Fed meeting and economic data for the third quarter all come after September expiration.

If the market finally settles into a trading range, investors will probably scramble to sell calls to generate income and use their newfound confidence to remove their protective puts. These activities should cause September premiums to melt faster than ice cream on a hot summer day.

Open Window

There is a small window of opportunity to capitalize on before September premium becomes oversold. For conservative investors, selling covered calls would be appropriate. For investors who desire enhanced returns, the combination of selling September strangles against long stock may be preferable. Using options that are still inflated from high implied volatilities increases your chances of success.

This strategy is not without risk. It could be bad if the stock moves down sharply over a short period of time, as it would entail selling out-of-the-money puts and buying the underlying stock.

For example, Millennium Pharmaceuticals ( MLNM) is a good candidate for the strangle combination. At a level of roughly $14.25, you could sell a September 12.5-15 strangle against long stock for a credit of around $1.40. If Millennium is unchanged at expiration, the return is 10%. If it goes out at $15 or higher, the return is 15%. That's not bad for a one-month trade. The break-even point at expiration on the downside is $12.85.

The stock looks enticing at these levels, but it's not expected to have any dramatic news in the next 30 days. As with any trade, you need to decide where you want your risk to reside. By choosing the strangle combination, you may be sacrificing some significant near-term upside potential for a more likely attractive return with more downside cushion.
Paul Haber is an options strategist and portfolio manager at Kramer Capital Management, which manages $60 million in hedge fund and other individual accounts and uses equity and equity options to optimize the returns on its portfolios. At time of publication, Haber was long Millennium Pharmaceuticals stock, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he welcomes your feedback.

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