I wondered last week whether we would see a return to the reflation rally or were entering a new regime dominated by mean reversion. The price action last week counts in favor of both, as we reverted to the closing highs of the prior week; I expect a more definitive answer by November options expiration.

The sale of out of the money equity index puts and/or put spreads I suggested last week worked out nicely, as prices moved higher and most of the equity implied volatility indexes printed five consecutive lower closes. For example, the SPX November 1020/1015 put vertical closed Monday at a $1.55 credit, and could have been closed Friday for a debit of about $0.35, a 34% return on capital risked. Our newsletter subscribers and managed accounts were positioned similarly.

The 30-day historical volatility of oil (USO) made new lows for the year, closing Friday at 27.24. [16] The last time this short-term measure of oil volatility was this low was in May 2008 amidst a strong up-trend. In contrast, recent price action has been relatively trendless; the spike to 1.6 in the implied/realized ratio this week suggests that any option buyers have seen considerably less volatility than they paid for a month ago. I would consider net buying options with crude below the $76 level.

Equity markets have been drunk on the wine of federal stimulus for most of this year. While the increased volatility in the latter half of last week could amount to a mere hiccup in the reflation rally, indicators suggest that more participants are concerned about an equity market “hangover” than at any time since the market bottom. The transition to a different market environment may have just occurred, and in the absence of any plausible catalysts, I’m not yet giving serious consideration to the possibility of a market crash, so the remaining likely regimes are a continued momentum-driven rally or the return of mean reversion.

I’ve introduced a new element on the Implied Correlation Index chart [10] – the dark blue line tracks the ratio of near- and longer-dated indexes (currently CBOE:ICJ and JCJ). The near term index, ICJ, expires in in January 2010, while JCJ expires in January 2011. The ratio, therefore, tracks the extent to which short term expectations of increased equity correlations are being mirrored over the long term. That ratio spiked higher on Friday and could easily eclipse the high set just prior to the March bottom in equities. Likewise, the VIX Premium Ratio [8] hasn’t been this low since March 9th. Note the negatively skewed daily returns in the S&P 500 over the last three months.[9] The VIX futures term structure is now (finally) flat.[7] These indicators all register the heightened concern among market participants, and give weight to the view that the momentum-driven rally may be over.

Unless the market is gearing up to give back all of the gains of September or worse, it makes sense to be selling out of the money puts or put spreads here in equity index options.

I think those October numbers represent a regularly achievable target, now that we’ve refined the Calendar Options strategy to better withstand short-term price volatility, strong intermediate-term price trends, and the current “volatility of volatility” (since the beginning of September, the VIX fell 7 points, recovered that entire drop, then fell almost 10 points only to bounce back 8 points in the week from Wednesday, October 21 to Wednesday, October 28). I was most amused last night when I attended a webinar on income options strategies (always keeping tabs on what other traders are doing) and one audience member wrote something like, “Calendar spreads don’t work in trending markets.” One look at our Calendar Options performance chart proves that Joe Novice couldn’t be more wrong.

If past performance is no guarantee of future results, one analyst’s expectations are worth about as much as…well, the claims of any hard-sell trading newsletter—and the hard sell is something we promise you’ll never get from the Condor Options group. All we ask is that you look at our long-term track-record, including (especially) risk-adjusted returns, and make your own decision about the value of the strategies we teach—which, by the way, is our primary mission: to teach you how to trade options for income well enough that you don’t need us anymore.

Performance Comparison – 3Q2009

Returns compounded monthly:

• S&P 500: +15.96%
• Dow Jones Industrials: +14.99%
• Russell 2000: +15.77%
• S&P 500 Covered Call Fund: +8.48%
• Calendar Options: +7.48%
• Note: the period measured is from expiration to expiration.

We calculate Calendar Options returns based on a model portfolio allocation. We initially size each hypothetical position at 25% of the total portfolio value at the beginning of each monthly cycle; with a maximum of three trades per month, this leaves at least 25% initially in cash for adjustments, if needed. Note that the model portfolio is not intended as a recommended allocation or as investment advice.

To see how the performance of our model portfolio since inception compares to a portfolio that’s 100% long the S&P 500, take a look at our Performance page. All performance figures include slippage (calculations are based on the actual prices at which the participating autotrading brokers were filled), but exclude any other transaction costs.

According to data supplied by the CBOE, the average daily volume traded in VIX futures for October 2009 has been just shy of 7000 contracts. The average for October 2008 was about 5200 contracts, or just above 6000 if we include the 25,000 contracts traded on September 29. The contract size of (and limited access to) VIX futures has kept them from being widely adopted among retail and individual traders, so it seems fair to suppose that activity in this product represents the opinions of “smart money” traders, or is at least not merely the result of this product becoming more popular.

However, it is worth considering who exactly is likely to be taking positions in VIX futures: derivatives desks with short volatility exposure in other assets, liquidity providers hedging VIX options sold to small traders (see the chart below), and large equity funds looking for portfolio insurance are all possible candidates. Increased trading by those sorts of actors can just as easily be interpreted as neutral or guardedly bullish, instead of ominous.

As the S&P 500 tests its 50-day moving average for the fourth time since March, it will be interesting to see how trading in the VIX complex responds to any sustained weakness in equity prices. The presence of traders making bets on increasing implied volatility is not, by itself, of particular interest – but it should be informative to see how those traders respond in the event that long volatility positions begin to play out favorably.

As I’ve noted on many occasions here, the relationship between spot VIX and longer-dated VIX estimates has not “worked” as a directional indicator for at least several months. [7,8] This looks like a genuine puzzle: the premium VIX futures traders are willing to pay and/or requiring in order to sell is too steep and has been too persistent to be dismissed as a phenomenon typical of the “wall of worry” that bull markets proverbially climb. But neither is that premium indicative of some impending crisis -at least, it wasn’t this summer and hasn’t been this fall. It is tempting to suppose that the effects of artificial government liquidity are overwhelming whatever information this relationship would otherwise provide. But whatever the cause, I won’t regard the VIX term structure data as meaningful until there is some new reason to do so.

RVX futures haven’t updated for a few weeks now; if there isn’t any volume next week, I will drop that chart from the report.[7]

Options on gold have been relatively expensive lately -even with the news-making price moves, option buyers haven’t received much of a realized volatility bang for their implied volatility buck. Ratio trades involving net sales of out of the money calls are one way to play the realized/implied imbalance as well as the vertical volatility skew. [12,13]

Options on USO, the crude oil ETF, have been fairly priced in recent weeks in implied volatility terms. [16, 17]