Options Trading: Where's the Volatility?

NEW YORK ( Top Gun Options) -- It has been an interesting week to say the least. After the release of the FOMC minutes from their last meeting, traders were shocked when it appeared that there would be no QE III.

At Top Gun Options, we believe the market is apparently suffering from short-term memory loss. Fed Chairman Bernanke did not say there would be another round of QE when he testified in front of Congress last month. The market feigned shocked, pulled back, volatility rose, and then...nothing. The market resumed its upward trajectory guided by the "invisible hand of the Fed."

So it's almost comical that the market has reacted to the "news" this week that the bartender has finally said "Last call!" Apparently they did not hear him the first time he said it, didn't believe him, or are now starting to feel the effects of a hangover. Welcome to the way "smart people" trade in this market. As a former retail trader, I know this can be extremely frustrating -- it's counter-intuitive. Or not.

Add to this news a rocket attack on Israel out of Egypt today and it's enough to make your head spin or wonder why volatility is so low.

This week our volatility barometer, the CBOE Volatility Index ( VIX), woke up from its slumber of $15 and nearly hit $18 yesterday and today we're hovering around $16ish. Yawn.

So where does this leave us?

At Top Gun Options, we're overall market neutral. We employ tactics, not strategies, that take advantage of a market neutral strategic mindset. Why? Because no one can predict what the right side of a chart will look like.

So our being market neutral also leads us to the ability to be long-term bullish on volatility while being short-term bearish. We currently have a position in our skill-based Primary Model Portfolio that is called a Diagonal on the iPath S&P500 VIX short term futures ( VXX). We bought deep in the money calls with a .8 delta that expire in January 13 while selling front month calls to the upside to help finance this call purchase.

Initially we sold the 25's and vol has not really spike at all on the news this week so we bought back those short calls and rolled them down to the 20 strike. The mission objective is to not fight the tape or not fight the Fed for that matter and follow the flow of that market.

Something has to give. Domestically, unemployment remains above 8%, more and more people are upside down on their homes and choosing to strategically default, the Fed is putting our children deeper into debt literally by the second, we don't have a budget (going past 1,000 days by the way), and oh by the way there's an election in November.

Across the pond rockets are raining on Israel and it's not a matter of if but when they will attack Iraq. Spain saw national protests this week and may have caught something from Greece. China is attempting to slam on the brakes, learning from the hard lessons of the U.S. financial train wreck. So when our banker decides the party's over, we could be in some deep...stuff.

Where does this leave us? Short-term bearish on volatility while having an insurance policy for when we wake up one day and see smoke on the TV coming out of Tehran or Iranian corvettes stringing mines across the Straight or Hormz.

Today we also placed a neutral trade on Gold via the GLD. The trade we placed was an April 151/155/165/169 Iron Condor that has a 70% probability of achieving max profit ($2300) by April expiration 16 days from now.

Bottom line: Volatility will return to this market, somehow, someway, and you need to be ready. Remember, the market can stay irrational longer than you can stay solvent. By employing market neutral tactics like Diagonals and Iron Condors, you can stack probability in your favor and potentially come out on top. Trading is combat. Don't end up getting destroyed.
This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

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