Wednesday, October 31, 2007

Selling Fear with a DryShips Bear Call Spread

About a week and a half ago Condor Options suggested an excellent mantra for those whose investing universe is populated by the likes of fear, greed, implied volatility, and the VIX: “Sell your fear to somebody else!”

It’s a simple concept, really, and one that shares much of what I try to do with the VIX. The hard part, of course, is to have the composure to calmly sell fear while others are panicking to such as a degree as to threaten to drive the price of fear even higher.

One obvious way to implement the selling fear strategy would be to do something like sell VIX calls whenever the VIX rises 15% above its 10 day simple moving average.

Consider a similar approach for individual stocks. For example, Adam at Daily Options Report posted an implied volatility chart that shows how implied volatility in DryShips (DRYS) has increased almost 50% in the past few days, as the stock hit an air pocket and fell 14% in a matter of minutes, a feat captured and analyzed nicely by Tim Knight at The Slope of Hope. Buoyed by Cramer, the continued bull market, and other more benign forces, DRYS has rallied almost 10% today, but now has some new battle scars.

It is possible that DRYS has put in a top and is now broken and vulnerable to bear attacks. Then again, this may be just another brief moment in time where the rocket ship shifts gears (see Tim Knight’s historical perspective above) before accelerating to the moon. I’m not brave enough to be long or short DRYS at the moment, but I will sell volatility at the current level. There are many ways to do this, but one way to harvest premium is with a bear call spread (aka short call spread, vertical credit spread, etc.) Thanks to the prodding I have received from several readers, I have provided an example of a bear call spread trade below from optionsXpress. Note that the trade consists of selling slightly out of the money calls and hedging/reducing risk by buying an equal amount of calls that are farther out of the money at a lower price. This trade is done for a credit, with the difference in cash in the trader’s account up front. Time decay is on the side of the trader, but the position should be actively managed, so that losses can be cut if DRYS moves sharply over 120 and threatens to go after its previous 52 week high. This is a high risk trade (a split of 120/130 or 125/130 would decrease risk significantly), but a lot less risky than a directional play on a stock with a triple digit implied volatility.

Now, did someone say something about an FOMC meeting…?

5 comments:

Condor said...

Hey, thanks for the link!

We are religious VIX and More readers around here.

Tim Knight said...

Ditto on that. Thanks.

Bill Luby said...

CROX (and other high fliers who miss earnings) should be a good candidate for a similar bear call spread as soon as it establishes some upside resistance and as IV stays high or goes even higher in the short-term.

Anonymous said...

Hello Bill,

Enjoy your blog, and have a question.

On key date 10-19, the HIGH for the VIX was 24.15, and the SP500 was trading down around 1490 intraday. Today (11-01), we closed near our low at 1508. Interesting that the exact HIGH for the VIX today was also 24.15. Is there a positive divergence insofar as we are at a higher SP500 level, with the VIX at the same level it was at when the S&P500 was 1% lower? Just wondering if you see this as significant. Regards, Jim P.

Bill Luby said...

Jim,

I have a lot of trouble comparing absolute VIX numbers (as opposed to say, where the VIX is relative to some moving averages) at two different points in time, largely because of the derivative nature of the VIX (also because it is comparing an osciallating number with a trending one.) For the same reason, I sometimes struggle with whether the VIX has valid support and resistance levels like typical individual stocks do.

That being said, you might have an interesting observation, though it is not something that immediately appears significant to me. I do think, however, that by the end of the day tomorrow we will know just how significant today's selloff was.

Good trading,

-Bill

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