Bottom Fishing for Cheap Options Is an Expensive Game

04/15/2010 12:01 am EST

Focus: OPTIONS

Adam Warner

Author, Options Volatility Trading

The CBOE Volatility Index (VIX) drift has now become something out of the movie "Airplane!" The VIX is now arriving, Gate 19; no wait, Gate 18; no, Gate 17...

Monday, we even saw a 15 handle, and Monday is a day that tends to see early statistical strength.

Someday it will prove prescient to simply net buy options again, but bottom fishing is a costly game.

Here's a comment that was posted on my site Monday:

"It's hard not to own options even if keeps not working. We know the kind of volatility this system is capable of producing. Someone will win big in Treasuries. I also suspect the banks are more than due for a big leg lower."

And he's absolutely correct. It is hard to not own options as the prices get better and better. And this action will not persist forever; we will surely get blips and spikes in volatility. And, yes, Treasuries and banks—and currencies and commodities, I would add—are as good a spot as any to expect it.

But here's the major problem: Every day you own an option that is overpriced relative to the volatility of the underlying instrument, you lose money. Here's how that works:

Suppose you own straddles in the SPDR S&P 500 (SPY), and let's assume implied volatility is constant at 15 (the number doesn't matter here). That position gets you longer into rallies and shorter into declines, so you have ammunition to buy dips and short rallies. Sounds great, but the flip side is that position costs you money in the form of daily decay.

For argument's sake, we'll say that decay is $100 per day, which also means it costs $200 per weekend. The realized volatility in SPY is a good proxy for how much you can earn trading the stock against your long gamma position. But realized volatility right now is about 7.5. So let's say that implies you can only earn $50 per trading day flipping (or riding) against your position.

So even at the very low 15 volatility, you lose $50 per trading day owning overpriced options, not to mention almost completely throwing away $100 for the two weekend days.

Now, if this anticipated volatility spike happens tomorrow, or even a week from tomorrow, you will feel great. You'll rake in enough to have offset that early decay. But if you sit with the position for a month, or two, or three, that's a huge hole to dig out of before it finally works.

Here's my point: Don't try to anticipate volatility spikes. You're much better off missing the absolute low watermark and then net buying options on the way up when they are actually working.

Everyone points to the one guy who caught it perfectly, but even that guy probably withstood a boatload of pain before it actually panned out.

By Adam Warner of DailyOptionsReport.com

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