When the world equity markets sold off in June, volatility spiked. On June 13, the Chicago Board Options Exchange’s volatility index — the VIX, which represents the volatility implied by options on the Standard & Poor’s 500 composite index — reached an intraday high of 24.

Interestingly, when the U.S. Federal Reserve Board raised rates by 25 basis points on June 29 and released a “soft” commentary, the equity markets soared — and volatility began to abate.

This is not surprising, because volatility is really a measure of risk. And traders perceive risk when the markets are falling, not when they are rising. After the dust settled, the VIX fell to its 200-day moving average of 13.5. (This average is my best estimate of fair value.)

Volatility is important to options traders because it is a major component in the options pricing model. Higher volatility means higher options premiums, which should benefit options writing strategies.

However, increased volatility at this stage usually means traders are reacting to noise with no clear direction. In this type of environment, options can move dramatically before expiry; but with no real direction, they will often expire worthless. The bottom line is that one strategy is not necessarily better than another in a volatile, directionless environment. In order to profit, options buyers and options writers must play the game very differently.

Options buyers must be prepared to take profits when they present themselves and to cut losses quickly. In this environment, it is quite probable that the underlying security will move sharply up or down before expiry, and yet the option will still expire worthless.

On the other side of the coin, options writers can increase their cash flow by capturing higher premiums. In a directionless market, options writers can be more patient, and often the best strategy is simply to hold the position to expiry, believing that most of the options written will expire worthless.

With that in mind, let’s look at an example. The S&P/TSX 60 composite index is being driven by changes in specific sectors — energy and commodities, for instance. When broader markets are focused on narrow sectors, it can cause short-term shifts that would defy normal trading patterns.

Given that, let’s examine a long and short options strategy using straddles on the S&P TSX 60 iShares (symbol: XIU; price on July 3: $65.85). Aggressive traders could buy, say, five XIU September 65 calls at $2.80 and five September 65 puts at $1.70. Total cost for this straddle is $4.50, which means it will be profitable for buyers if the XIU moves above $69.50 or below $60.50 between now and September.

More conservative traders who already own shares of the XIU or are considering the purchase could look at buying 500 shares and write five September 65 covered straddles. For straddle writers, the position will be profitable if XIU is between the upper and lower ranges mentioned above at the September expiration. What’s interesting is that both strategies could be successful under the right conditions.

If this is truly a directionless market, there is a real chance that XIU will be trading somewhere near the strike price by the September expiration. If you own XIU today, this may be an opportunity to collect some additional cash flow and to enhance your position, should the market decline.

Writing the straddle means you receive $4.50 a share in immediate cash flow, taxed as a capital gain. If XIU is above the strike price of the call at the September expiration, the short put will expire worthless, and you’ll sell your XIU shares to the option buyer. The total return, should the stock be “called away,” is 7.3% between now and the September expiration, not including dividends.

Should XIU be trading below the strike price of the short put at the September expiration, the September 65 calls will expire worthless. At this point, you would be obliged to buy an additional 500 shares of XIU at the $65 strike price.

In this case, you would end up with 1,000 shares of XIU at an average cost of $63.18 (i.e., 500 original shares at $65.85 and 500 new shares at a net cost of $60.50 [strike price less the two options premiums]). For conservative investors, the straddle write has value if you want to dollar-cost average into new shares (i.e., the put is assigned) or enhance your cash flow in a period when the market has no clear direction (collect two option premiums, taxed as a capital gain).

@page_break@Straddle buyers could also make money in a directionless market but, to do so, they would have to be willing to move quickly to capture short-term stock price aberrations. Holding a long straddle to expiry has a much smaller chance of producing a profitable outcome.

In this case, should the market drop sharply, you would sell the puts and hold the calls, waiting for a rebound to occur. Similarly, if the market were to rally, you would sell the calls and hold the long puts, looking for a market pullback. Again, this assumes we are in a directionless market environment.

Another strategy is taking advantage of company-specific events, such as taking advantage of market moves related to earnings releases. Again these are short-term aberrations, but in this type of market, the moves could be exaggerated. IE