Estimating The Future
Suppose you have conducted a careful analysis of the implied volatility of the OEX options, as represented by the VIX, and conclude that the VIX will decline. Suppose also that your analysis of the OEX tells you that the OEX will rise. These two conclusions are consistent with typical behavior–when the OEX rises, the VIX tends to decline, and when the OEX declines, the VIX tend to rise. How can you exploit this situation?
You want a position that will gain if the VIX declines, and gain also if the OEX rises. A long call will benefit from a gain in the OEX, but it will lose value relative to the OEX if the VIX declines, and the gain and lost will offset one another. Must a call necessarily gain if the OEX rises?
The answer is no. If the VIX declines enough, the call can actually lose value in an OEX rally. Suppose the OEX closes today at 670, and on the close you sell the 670 call for 19.5, a little over its theoretical value, with the VIX closing at 24 and 20 days to expiration.
Tomorrow the OEX rallies tomorrow to 675, but the VIX declines to 19, and the call price continues to adhere to theoretical value. The theoretical value of this call at an OEX price of 675 and a VIX of 19 is 18.06, which means you lost money. Why did that happen? Because the gain in OEX value of the call was offset by an even larger loss in theoretical value due to the decline of the VIX from 24 to 19.
The long call position gained from the rally in the OEX, but lost from the decline in the VIX. You want a position that benefits both from a rally in the OEX and a decline in the VIX. Two kinds of single option positions gain from a rally in the OEX: long call, and short put. Does a short put position gain in an OEX rally? Certainly it does if the VIX does not rise. Suppose you sell the 670 put with 20 days to expiration for 16 7/8, a little less than its theoretical value when the OEX is at 670 and the VIX is at 24, and suppose again that the OEX rallies to 675 and the VIX declines to 19, and that the put price follows its theoretical value. Then the put price moves to 10.68, producing a nice gain for you.
This is not to recommend the naked sale of puts. You would probably want to find a hedge for this position, just in case. You might purchase, for instance, an in-the-money put such as the 690 with the same expiration, with a theoretical value and price of 28 5/8 with the VIX at 24. This put would lose almost $3 of value in this rally, moving from 28 to 25 1/8, but the loss would be more than offset by the 8 3/8 gain from your short.