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Got this in email yesterday:

Looking at FNM this morning it was trading 4.85. The Sept 5.00 call was trading about 1.25. I realize this is just because the vol has blown out and selling this vol is probably the right thing to do. Were it a more normal situation I know a strangle, straddle, butterfly or condor would be the way to play this. (But not possible here because no reasonable strikes below atm.)

One of my friends suggested writing the 5 call and buying the stock… doing a covered call to sell the vol. this seems wrong to me intuitively but I can’t articulate why. If you were hell-bent on writing options here writing a call spread in sept (5/6 5/7 etc) would probably be the way to go, but I can’t explain to him in simple English why the covered call strategy is a poor choice here.

Giuseppe Franco

Wow, didn’t realize you owned the company (or anything about it). Or were an options trader.

OK, confession; that’s not the emailers real name. Here’s my response.

I guess it all depends on the direction you want to play for. If you want to play a direction at all.

A covered call write is almost exactly the same thing as a naked put sale, so it’s a bullish play. Selling a call spread is a conservative bearish play, you’ll max out if the stock closes under 5. You only risk (1-the spread premium) but can only make the spread premium.

If you want to simply sell the volatility, and don’t have a directional bias, the proper play is to sell either straddles or strangles on a delta neutral basis. By delta neutral I mean either sell calls and puts with the same delta, or tweak the quantities a little bit.

In a follow up email, Guiseppe admitted he knew a covered call was the same thing as a naked put, but “our reaction to the short put was “no way” while, for some reason, the covered call seemed acceptable…….biases are funny things, no?”

Yes on the biases, and it’s pretty easy to see why Giuseppe says that. Everyone on Wall Street tells us so. Covered calls are considered some sort of “safe” income generation, while naked puts are for insane dice-rollers, Yet they have exactly the same risk/reward profile. P&L’s might differ modestly as interest rates and dividends fluctuate, but for all intents and purposes they are identical. And in fact put sales were wildly more preferable until they adjusted margin treatment a couple years ago (the stock and the call did not offset for margin purposes).

Bottom line is that both are conservative bullish plays, especially in a stock that is already a call option in and of itself. If you are wildly bullish on FNM equity for whatever reason, better to just buy the stock. It’s highly likely somewhere, someday, someway (great Marshall Crenshaw song by that name btw, can’t find the real video though, so here’s “Whenever You’re on My Mind“) FNM and FRE will do a quick short-squeezing double on the way to zero. That double might be 2 to 4, but it happens at some juncture every time.

If you’re tracking the Dick’s (DKS: Sporting Goods) to Dicks (LEH: Loaning Bads) relationship, big change of direction lately as one (DKS) not looking so much like wallpaper any more. Probably the main factor is that one of them is selling the Speedo Michael Phelps line of everything and the other is selling anything they can get a bid on.

Volatility is of course soaring in LEH, although not quite the obsene 225 volatility of early July as you can see on the chart. Guess it’s more of an orderly implosion this time around. You really have to look at pure dollars when a stock gets to these levels also, as opposed to volatility. And the Sep. 13 straddle goes for about $4.40 or so. If you think the stock will sit here until expiration, you can actually sell that and buy the Oct 14-12-5 strangle for just about zero. So clearly the market is telling us whatever cosmic news we breathlessly await, will hit before expiration. Earnings are right about expiration day, but incredibly unlikely it goes on until then.

So how mediocre is volatility these days?

How about a spot where by all rights options should see a vertitable spike now, Goldman Sachs (GS)?

You have an ugly stock chart. You have an ugly stock chart with historical volatility on the high end. And you have an ugly stock chart with high end historical volatility in an earnings month.

And you have not much going on. V

Options sit in the mid 40’s, an incredibly average reading for GS.

I’ve noted FSLR and AAPL options recently as spots that look cheap to me, but in a way GS is worse. FSLR I could make a case needs to bust out of it’s recent range and/or break below it’s nearby 200 Day MA to get options players nervous. AAPL similar but in reverse as it has not violated any important tops.

GS though? It acts like dreck and has a report due soon that is sure to generate massive interest. And yet we have really nothing going on.

That’s complacency imho.

So if you can’t say something nice, don’t say it, right?

So what to say then of these commodities?

Well, commodity stocks are starting to outperform the underlying. Popped up GDX vs. GLD and SLV, and IYE vs. USO here, and all are in “X”s. GDX veritably bullish vs. SLV.

So if the stocks are “leading” a bit, maybe getting close to a turn?

As the options go, don’t actually have any in SLV. GLD does, but not a whole lot of history. Volatility is about 30, which is pretty much *record* high. But again, only 3 month’s of trading to look at. The best guideline is historical volatility, and that has ranged from a low of 12 last September to a high of 29ish in both November and March.

So if we had a GLD VIX, it would look a bit like our actual VIX did when it hit the mid 30’s a couple times this year. That is, a bit extreme.

That’s the bullish *news*. The flip side is that much like in everything else that implodes, the world seems determined not to miss THE buying opportunity. As per Nick at Schaeffer’s, lots of options interest in call options on gold shares.

Using the Gold Bugs Index (HUI) as a metric, Nick has this.

Two things stand out to me. The first is the break of support near 400. The second is the oversold reading shown on the Relative Strength Index (RSI).

Pulling this all-together, it seems we have the following situation…Gold stocks break support and are then hit with aggressive selling pressure which pushes them into oversold territory. Traders then jump on the group and start trying to call a bottom.

Guess who’s got *hand* this expiration? It’s the options shorts. Even the movers of Wednesday, the ags and energy et. al. simply moved into middle ground sort of spots. And with no follow through, no real whipsaw action like we saw in, say, July, when financials went to wallpaper and then soared all within a few days.

So if you something near strike, got some serious likelihood it stays there.

And what better time to review the mechanics of pinning than expiration day.

The way it works is a cabal of powerful AMEX market makers meets on Thursday nights and goes over each stock and decides where it will close.With a particular emphasis on causing the most pain to the most customers. Then they come in Friday and set their markets accordingly.

OK, just kidding.

A pin is the tendency of a stock to gravitate and close at/near a strike price. A pin is most common when the open interest on the strike price is high relative to typical volume in the stock, and when volatility of the stock is relatively low. The dynamic is that option longs on the strike are forced to buy and sell stock around the strike in order to offset the decay they are about to lose on their positions. That causes pressure on the margins on the stock to gravitate around the strike. If the option shorts are in control, as they seem to be this cycle, then option longs are likely to cause a self-fulfilling prophecy against their best interests.

It’s one of those times of year again where I like to pre-warn about something. Ignore all volatility indices and measures. Or at least take them with a grain of salt.

All volatility measurements basically take all the *fixed* info, I.e. the stock price, the strike, interest rates, dividends, time until expiration, and price of the actual option and then *solve* for the unknown variable; volatility.

But what that formula does not account for is that all *time* is not created equal. What I mean is as of Friday, we face two weeks of late summer that see notoriously high traffic in the Hamptons and notoriously low traffic in the pits. It is traditionally a very slow stretch until after Labor Day, which is conveniently almost exactly halfway through the September expiration cycle.

In other words, tomorrow, September options will have 35 calender days until expiration. But in reality, the first 18 of them figure to be very non-volatile.

Option traders anticipate this, and condense time to some extent. What that means is they effectively pretend options with 35 days until expiration really only have 25 days until expiration, something like that (I’m making up the number to make the point). But remember the volatility calculations you see everywhere don’t know this. They basically assume the calender is correct. And thus volatility looks cheaper. But it’s strictly a calculation quirk. “Real” volatility and pricing of fear has not budged, it’s only a realistic discounting of “time” that has gone on.

Perhaps the simplest way to account for this is to avoid watching the actual VIX for the next couple weeks, and pay more attention to VIX futures and options. These are trading markets, and as such will price in the holiday. Right now they expect about a 23 VIX in September. It’s likely over the next couple weeks that the *cash* VIX will drop, while this will stay constant. If that in fact happens, i.e. you see an unusually large premium from the futures to the cash, it’s not all that meaningful. If it deviates however, that’s something to note.