Most of the in the money October calls were exercised or sold, as we expected.  But as discussed yesterday, they had no time value and a very low implied volatility, 14, right where the historical volatility is.

I sold the Nov 46 calls and bought the stock.  Actually, I jumped the gun and did the buy / write day before yesterday.  Today when I went to unwind the position, I came out flat.

Generally, if you are taking no risk, you can only expect to earn the risk free rate, which is very low. That is what is going on here. I have to figure out which risks I can take on with this strategy to make a decent return.

Back to the drawing board.

Why Bother?

Why try to figure out a way to capture dividends? You make pennies. But they are high quality pennies. Any time you can lock in a return, even a small one, that is very high quality money. We will do the return calculation at the end to see if it is worth it.

Today’s Target

Phillip Morris (PM) goes ex-dividend tomorrow, 24th September, paying $0.58 in a few weeks. So today is the come date. In the money call owners who want the stock will call it away today. And call owners who fear a drop in the value of the call will sell their call today.

So I thought that I would buy stock and sell calls so that the stock would be called away. I would get the time premium in the call. So I need a call that is in the money and has a small enough time premium to make it worthwhile for the call owner to call it away.

Which Call To Sell?

This is the Oct in the money call option chain, 7:30 this morning, before the market opens. (Click on the picture to enlarge.)

The 48, 47, and 46 calls are trading with the dividend payment already accounted for. Notice that their implied volatility is lower than the historical volatility of the stock. The deeper in the money calls’ bid and ask bracket PM’s price, 48.93. they have no time value left. So there is nothing to do here.

Let’s look at the Nov option chain for the in the money calls.  (Click on the picture to enlarge.)

We can make a table to make it easier to compare.

To me, it looks like the Nov calls with strikes 46 and lower will be called away. The 47s and 48s have too much time premium and so are too expensive to be called.

As a further check that this is the baseline implied volatility level, we look at Dec too.  (Click on the picture to enlarge.)

Expected Return

So buying a share of PM and selling a 46 Nov call would cost $48.93 – $3.2 = $45.78 and if it is called away, we make $0.27 time premium. So the return is approximately one half of one percent. The risk is that the stock isn’t called away.

I will report back later.

Safe Dividend Capture

Call holders don’t get the dividend, so my idea was to buy the ETF and sell in the money calls. If I sold September calls, they would have, most likely, been called away since there was very little time value left in them.

So I sold October 103 calls for close to $5. There was $0.70 of time value left in them making them too expensive to call away for a $0.52 dividend.

What I thought would happen is that the calls would drop in value by $0.52 * delta or about 40 cents, reflecting the drop in price of SPY. That would be my return from the trade, minus transaction costs and slippage.

This morning, as expected, SPY was trading lower, but the calls were unchanged!

Solution To The Mystery

I looked at the implied volatility of the calls at yesterday’s SPY price, and it was 14, the same as the historical volatility of SPY. Today, at the new SPY value, the implied volatility of the calls is 21, in line with all the other options.

So the option was already discounting the dividend yesterday.

The underlying for the VIX is the futures contracts so, for example, calendars do not work the same way. The out month moves independently of the near month.

The 30 day historical volatility of the VIX is 84% while the at the money options, at 25, have an implied volatility of 64%. Right now VIX is trading just below 25, so it would be a coin flip if the puts end up in the money or not.

OK, apparently caused lots of dissenting opinion in regards to slapping on a spread that involved going long VXX and short SPY near term options.

So let me clarify a few points.

This is just a convoluted way around a relatively simple trade, an SPX or SPY calender. So what if we forget VXX and VIX futures exist. The basic thought here is

when volatility caves, I generally would prefer owning calenders. That involves buying longer dated options at likely a higher volatility than I am selling the shorter term options. It gets me short gamma and earns money in the form of time decay.

You have to look at this as two separate transactions though. The short side of the options will earn me money if the realized volatility between now and expiration is less than the volatility I sold them for. Yes, part of that trade likely involves chasing stock into strength and shorting it into weakness. The idea is to lose less doing that than you earn in options attrition.

The long side of the calender is more of a bet on implied volatility at least holding steady. You will not lose all that much time decay, but you are at risk of a move lower in volatility. But if you think options volatility is a buy longer term, you are OK with that.

So combine the two and you are effectively betting on longer term implied volatility to outperform shorter term realized volatility. If you think that’s a good bet, a calendar makes sense.

Using VXX or a VIX future in lieu of a longer dated SPX or SPY option is not identical, but you will win or lose with it in a similar pattern as above.

But it’s important to remember however you chose to go long a longer dated option, it’s not a big deal if you “buy” higher volatility than you sell. It’s two different time frames and two very different bets, there’s no reason they will or should carry the same volatility. A few weeks ago they all did carry about the same volatility. That’s more unusual than not.

So what’s the risk in buying a calendar, or buying VXX and shorting SPY options?

It’s not that some small volatility difference between the two cycles will revert to 0. There are 2 big risks however. One is that realized volatility, which you are effectively shorting, will explode and longer term volatility will not lift as much. You would have got hit massively with that last Fall. Which is why I don’t like this position in a rising volatility environment.

The other risk is that all volatility caves in. Your short volatility will only earn you so much, I mean your options can only go to zero and you will get lousy prices trying to roll them. Meanwhile your VXX or VIX future or longer dated SPY straddle has gotten mauled.

Post getting long here. To be Continued.

I had suspected that I might get some pushback from some of the charting purists about limiting the scope of my Fibonacci retracement lines to a post-Lehman world, particularly since the SPX had already corrected more than 300 points prior to the Lehman Brothers bankruptcy filing.

My explanation, quite simply, is that the investment world changed radically in September 2008, both from a fundamental and technical perspective. I even used the term Market 2.0 to describe the situation at that time. Technically, at that time the markets transitioned from a measured decline to a series of free falls that took ten day historical volatility to as high as 100 in October.

In the chart below, I have superimposed two different sets of Fibonacci retracements on top of almost two years of daily SPX data. The dotted blue lines repeat my post-Lehman world view as presented in SPX and Fibonacci Resistance at 966 earlier today; the solid green lines reflect a more traditional approach to Fibonacci calculations, using the October 2007 high of 1576 as a point of departure. I have highlighted the 50% retracement levels for both sets of calculations, using blue arrows for the post-Lehman data and green arrows for the data going back to 2007. Note that the difference is a full 155 points: 966 in a post-Lehman world and 1121 using the 2007 high.

If the markets continue to rally, I would encourage readers to pay attention to the green Fibonacci lines. In the meantime, I continue to believe that the post-Lehman period – at least while the SPX remains below 1000 – is the appropriate time frame on which to focus our analytical lens.

[source: StockCharts]

Further to this morning’s pre-market post, Volatility in Context with VIX at Pose-Lehman Low, today’s 0.35% drop in the SPX means that it has now been four days since the S&P 500 index has moved more than 0.35%.

The range-bound trading is taking a heavy toll on historical volatility (HV), with today’s action pushing the 10 day HV in the SPX down from 21.54 to 18.10 – the lowest reading since September 3, 2008.

The graphic below attempts to put the current historical volatility levels into the context of the past 2 ½ years. Note that the current 10 day HV of 18.10 fits right in the middle of the range for this measure during 2007 (a year of very low volatility) and the pre-Lehman portion of 2008. In fact, given the recent historical record, I would be quite surprised to see 10 day HV fall any farther than the current level for at least another month or two.

Of course the VIX can continue to decline in the absence of falling volatility, but at some point historical volatility begins to provide some semblance of a floor below which the VIX is unlikely to remain.

On the other side of the coin, investors should also be aware that it has now been 26 sessions since the VIX was above the 35 level. If there is a catalyst (such retail sales numbers, housing data, industrial production statistics, Treasury auction results, the FOMC meeting in two weeks, etc.) that will change the volatility equation, then it is reasonable to look to 35 – not 40 or 50 – as the target for a VIX spike.

Finally, with volatility expectations shrinking almost on a daily basis, those who may be interested in speculative buying VIX out-of-the-money calls might find them a lot cheaper than anticipated – and perhaps a lot cheaper than they will be in another week or two.

[graphic: VIXandMore]

Yesterday the VIX closed at 28.27, its lowest close since the VIX ended the day at the 25.66 level on September 12, 2008 – the Friday before the Lehman Brothers bankruptcy filing.

In addition to the new lows in the VIX, a number of measures of historical volatility (HV) in the S&P 500 index are also at levels not seen since the week of the Lehman Brothers bankruptcy. These include 20 day HV (24.65), 30 day HV (25.50) and 50 day HV (28.57). Further, while the 10 day HV has not yet fallen below recent May and January lows, at 21.54, this is the type of number that makes the 30+ VIX advocates more than a little nervous.

The culprit is recent range-bound trading in which yesterday’s 3.29 point gain in the SPX is actually the largest daily change in the past three trading days. For the last six sessions, the SPX has hardly moved at all, which has driven historical volatility – also known as realized volatility – dramatically lower.

The chart below shows the trends in the VIX and historical volatility in the SPX since last September. Note that since the March lows the VIX has been falling in conjunction with the highlighted 10 day and 50 day historical volatility measures. Note also that the last three times 10 day HV got significantly ahead of the VIX (1/5, 2/5 and 5/6) each time this was a precursor to topping action in the SPX. As the 10 day historical volatility in the SPX gets ahead of the VIX once again, it is reasonable to ask whether this pattern will continue and we will see another topping pattern in the next few days.

[graphic: VIXandMore]

I don’t know.

I like to think as far forward as options expiration, next one is 20th June.   What is my best guess of what might happen until then and how can I make a few profitable trades.

I deeply respect people who can buy GE now and wait patiently for the economy to improve and GE to clean up its balance sheet and grow all its businesses.  I can’t do it.

My last boss at Millennium used to talk to floor brokers all the time and ask them, Why is the market up?  Why is it down?  The stories they told him satisfied him.  “Soros has split a large order among five brokers and it is getting executed …”  Something like that.

Trading shows how well aligned I am with reality.  I like models and finding and testing a trading strategy.  But all trading strategies bother me.  What is left out?  What are the hidden factors that are really driving the profit in the strategy?

In an up or sideways  market, you can do really well selling puts.   It is simple, and with a little technical analysis and no news to move the stock, like earnings, you can get some comfort that the put will expire worthless.  Also, you can use an options calculator to calculate the probability of success  based on the historical volatility.   That is comforting too.

In a down market selling puts will kill you.  So you have to know the difference short term, until the next expiration.