Tue, Jan 19, 2010 | Jared Woodard
Last week, I noted the very wide spread between short-term realized and implied volatilities. Although the selloff on Friday alleviated conditions slightly,  the spread is still large enough that traders inclined to be net sellers of options need not fear occasional daily increases in realized volatility.  The smartest trade in equity index options at this point might be to sell the wings and buy the guts on a dollar-neutral basis, delta-hedging as needed: because it is long gamma, an at-the-money (ATM) straddle would profit from any uptick in realized volatility, while short vega from out-of-the-money (OTM) strangles will help if implied volatility continues to fall. We can call this a “volatility convergence” trade, since the position is maximally profitable when the underlying is 1) more volatile between now and expiration than is currently implied by ATM options, but is also 2) less volatile by expiration than is currently priced into the OTM options. In my view, such a position should be constructed using options in the same expiration cycle to avoid the complication of term structure dynamics. Using an ATM straddle and short strangle legs with 15 delta, the maximum profit at February expiration for this trade would be near 1065 or 1185 in the S&P 500.
Oil has been much less volatile than USO options implied 30 days ago, so this may be a decent opportunity to sell some short-term premium against longer-term core long positions. [16,17]