Bernie Schaeffer Schaeffer’s Investment Research Inc.
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"During the past week, institutional investors have started selling stock options that expire in December 2010 and buying others that expire in September and October 2009. What does the action suggest? That some 2010 options are overpriced -- as implied volatility is so elevated as to suggest that the credit crisis won't abate. (Jeff Shaw, senior trader for Timber Hill) says September '09 options' volatility on the Standard & Poor's 500 Index is as much as 20% lower than that of December 2010 options ... So why the disconnect? The answer's to be found in options-pricing-model peculiarities. 'As the market slows down, that leads to lower front-month volatilities, as pricing models used by most market makers sense that historical volatility is dropping,' Shaw says, yet 'it takes more time for longer-term volatilities to incorporate the recent relative calm in their prices' ... This quirk leads some traders to essentially sell the future in order to finance near-term positions predicated on the Standard & Poor's 500 Index's bursting from its 880-to-940 trading range ...'Think of the market now as becoming a tightly wound spring,' Shaw says. 'Eventually, it will break out of its range. And when it does, owning gamma -- or short-term options that are more sensitive to price movement -- will be profitable against long-term, higher-volatility options.'"
(Barron's – "The Striking Price" – 6/29/09)

Schaeffer's addendum: I wanted to make sure I commented on this very interesting piece before the long weekend.

I think the scenario laid out by Mr. Shaw is internally consistent and logical, but I would suggest considering some other factors before completely buying into the theme of selling long-dated premium to buy short-term premium.

I don't know if the fact that long-term options are richer than short-term options is due to "option pricing model peculiarities" or the fact that long-term historical volatility (HV) is, in fact, much higher than its short-term counterpart. The 10-month HV of the S&P is at nearly 50%, its highest level in the modern era, while 10-day HV hovers in the 20% area. If you believe that some type of mean reversion will occur that will pull long-term volatility down to more "normal" levels while nudging short-term volatility higher, then the trade described in this piece makes sense. And we all "know" that volatility is mean-reverting, don't we?

But in recent weeks at least, the long short-term volatility trade has been extremely difficult, with the S&P currently flat relative to its early-May levels and with intraday volatility often at single-digit levels. And the fear would be that the short-term volatility buyer experiences death by a thousand cuts, while ultimately being exposed through a short position in long-term volatility to a huge market move.

Bernie Schaeffer:
• Developed Expectational Analysis®, a proprietary, three-tiered method of options analysis combining technical and fundamental studies with the analysis of investor sentiment.
Publisher
• In 1981, Bernie launched the newsletter, Bernie Schaeffer’s Option Advisor. Serving as senior editor since inception, Bernie has led the Option Advisor to become the nation’s leading options newsletter. Features: market commentary, specific trade recommendations, and trading strategy.
• Launched SchaeffersResearch.com, in 1997. A four-time winner of Forbes “Best of the Web” award, the website has also received positive mention in Barron’s, AAII and The Wall Street Journal Guide to Online Investing - “An independent options site that is one of the best for providing primers for both novice and advanced investors.” Features tools, quotes, data, commentary, and education.
• 10 Days to Successful Options TradingSM – This multi-media home study program teaches options basics. Learn fundamental strategies with hands-on application exercises and examples.
Author
• The Option Advisor: Wealth-Building Techniques Using Equity and Index Options (1997)
• New Thinking in Technical Analysis: Trading Models from the Masters – The industry has viewed Bernie’s Expectational Analysis® methodology as a groundbreaking approach to trading. Proof of this came with the publication of this new book by Bloomberg Press. One of twelve authors, Bernie was honored to be chosen from hundreds of market analysts to explain his methodology.
• Writes a monthly options column for Bloomberg Personal Finance magazine.
• Multexinvestor.com regularly calls on Bernie to contribute to their “Analyst Corner.”
Awards and Recognition
• Three time winner of The Wall Street Journal stock picking contest.
• Ranks fifth among market timers tracked by Timer Digest for the past decade.
• Dick Davis Hall of Fame inductee for his bearish posture ahead of the 1987 crash.
• He is known for successfully maintaining a bullish market posture throughout the 1990s.
• The Market Technician’s Association (MTA) awarded Bernie “Best of the Best” in 1997 in the field of Sentiment/Psychological Analysis.
• Bernie is regularly featured on investment chats on Yahoo! Finance.
• Bernie’s views on the stock market and the economy are regularly quoted in The Wall Street Journal, The New York Times, BusinessWeek, Investor’s Business Daily, and USA Today.
• Both Barron’s and The New York Times have featured Bernie in “Question & Answer” interviews.
• Recognized as a CNBC “Market Maven.”
• Appears regularly on national financial broadcasts such as CNBC, CNN, Bloomberg Television, the Nightly Business Report, Wall Street Week with Fortune and Fox News. Also serves as a guest host on CNNfn.
• Frequently invited to speak at national investment conferences and seminars.
• Regularly sits on Options Industry Council panels around the country.
• One of 50 market strategists appearing in BusinessWeek’s 2001 market forecast.