Except for the market meltdown of 2002, selling cheap summer premium has been a historically successful trade for volatility traders. Just because the CBOE Volatility Index, or VIX, is at multiyear lows doesn't mean it can't go lower.

In its purest form, the VIX is the volatility trader's expectation of the S&P 500's movement over the next 30 days. Volatility traders are not making a market call; rather, the VIX represents only their best guess at the amount of realized volatility that can be captured by gamma hedging. A low current VIX merely indicates that volatility traders expect the level of actual movement in the S&P 500 to remain muted over the next 30 days.

The VIX is now at 16.50, but the 30-day historical volatility (actual movement) for the S&P 500 is below 9.

As I mentioned when the VIX was at 37 in 2002, volatility traders are not fully adjusting to the declining volumes and reduced speculative demand in the current marketplace. They're still clinging to hopes that the more recent 20 to 30 range will become the norm for the VIX. From 1991-96, before the tech explosion, the VIX traded in a range of 10 to 20. Just as gymnastics judging throws out the highest and lowest scores, the volatility mania from late 1998 to early 2001 should be discarded if we really want to predict where volatility levels should be.

Right now, long premium holders seem to be fighting the tide and are unable to cover the option decay. If they continue to lose money, they may aggressively hedge at tighter levels to recoup some of their losses. This would cause the VIX to trend even lower.

Unless actual SPX movement increases by more than 50%, short summer premium will continue to be a winning trade.
At time of publication, Haber was short summer premium, although holdings can change at any time.

Paul Haber is president and portfolio manager of PSH Capital Partners, LLC, an event- and catalyst-driven hedge fund. He is also registered with Leeb Brokerage Services Inc. and manages individual accounts. Haber was previously portfolio manager and option strategist at Kramer Capital Management, which managed a combined $60 million in hedge fund and separate accounts. 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 and invites you to send your comments to phaber@thestreet.com.

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