Implied volatility, as measured by the Chicago Board Options Exchange’s volatility index, a.k.a. the VIX, rocketed to 42 on Sept. 18. This five-year high marked the short-term bottom in the Standard & Poor’s 500 composite index. When the market rallied on Sept. 19, backed by the prospect of a government bailout, the VIX immediately declined to 32.

So, why is this data important? To put it simply, the VIX is a tool that allows us to quantify the emotional response of investors to activity in the financial markets. Emotions provoked by market events run the gamut from fear to greed, and instantaneously show up on the VIX.

Not that you can reasonably profit from an emotional roller coaster that careers up and down on an intraday basis. But, on a longer-term basis — which is to say, weekly or monthly — the VIX provides information that can be useful when establishing a forward-looking portfolio strategy.

For example, since the middle of last year, when the credit crisis first surfaced, the VIX has remained consistently between 20 and 30, considerably higher than its average level of between 10 and 20 during the previous four years. Essentially, the VIX is telling us that the “fear” factor is alive and well — and likely to remain in force for the foreseeable future. This suggests that options-writing strategies are, on average, probably the best choice within a portfolio.

Covered call writing is one approach — as is the corollary to that, writing cash-secured puts — particularly on commodities companies, including gold, energy and agricultural. Even the U.S. financial services sector might be included. Although its volatility remains especially high, there is now a likely floor to valuations, supported by none other than the “Warren Buffet” factor following his decision to take a large position in Goldman Sachs Group Inc. last month. In this context, covered calls on financials such as New York’s Goldman Sachs, Morgan Stanley & Co. Inc., Citigroup Inc., Bank of America and San Francisco’s Wells Fargo & Co. come to mind.

Another strategy born of the bailout that probably has merit is Toronto-based BCE Inc. If you buy U.S. Treasury Secretary Henry Paulson’s argument that the bailout will allow banks to get back to the business of loaning money, then the BCE deal will be a classic case study. Being a creditworthy debt issuer, it certainly fits the model should the deal go through at $42.75 a share.

As of late September, BCE was trading at less than $38 per share. As you would receive $42.75 on this deal if it goes through as planned in December, your return over the next three months, on the current price, is 12.5%. That a successful conclusion to this deal yields such a healthy return implies that many stock traders are sitting on the fence as to whether this deal will actually get done.

The same cannot be said for the options market. I note, for example, that at the time of writing, the BCE December 42 calls were bid at 50¢. If this deal goes through as expected, the Dec 42 calls would be worth 75¢ at expiration. If the deal doesn’t go through, these calls expire worthless. Clearly, someone or some group in the options market believes the deal will go through as expected and are willing to pay up with a 50¢ bid to play the takeover game.

If we flip our position from being a buyer of the BCE Dec 42 calls to being a seller, we begin to see the benefits of options writing. In this case, with the calls at 50¢ at the time of writing, you can buy BCE shares for less than $38 and sell the Dec 42 calls. The premium received from the sale of the call reduces your cost of buying the shares, and all you give up is the last 25¢ in the value of the takeout price. (You will receive $42 for your shares and you get to keep the 50¢ a share premium.) A classic case study in getting paid to hold risk.

On a macro basis, options writing makes even more sense. You could argue that the bailout rally on Sept. 19 had more to do with covering shorts than with a real sea change in market sentiment. In other words, the financial markets in general are not likely to surge to new highs anytime soon. A genuine turnaround, in fact, seems unlikely until market participants begin to focus on fundamentals such as earnings, consumer spending patterns, the depth of the U.S. recession and the long-term impact the bailout will have on U.S. government deficits.

@page_break@At the moment, the only fundamental on the minds of traders is whether or not the U.S. housing market will stabilize anytime soon. If we want a blueprint for the stabilization time frame, you might look at the Resolution Trust Organization, which was formed in the early 1990s to bail out the U.S. trust industry. It took a year after that bailout to get the financial markets rolling and two years after the bailout for the U.S. to climb out of that recession, leading to the stabilization of house prices. Thus, we may get a real rally around the time of the Vancouver Winter Olympics in 2010.

Of course, time is the one positive the U.S. government plan brings to the table. Assuming that the U.S. taxpayer ends up with a basket of bad real estate, the government can presumably take a measured approach to unwinding this newfound portfolio. That makes this bailout an investment in the U.S. government balance sheet rather than an extension of debt.

The risk, of course, is that a new president/Congress decides to intervene politically, on the basis that we “must keep Americans in their homes.” In which case, all bets are off.

In terms of the politics of home ownership, it won’t matter who sits in the White House. It will come down to how much mileage a new president can get by keeping homeowners in their homes, regardless of economic considerations. And the risk is real, because we have precedents for home ownership glad-handing. Make no mistake, it was the politics of home ownership, not economics, that got us into this mess in the first place.

Therefore, as we don’t know the potential political risk, we again come back to the options-writing strategy, one that provides benefits if we see more of the same — that is, a volatile environment going nowhere but having possibly established a near-term bottom.

The benefit will be getting paid to hold volatility in a trading range environment, that is, one in which there is heavy resistance at higher levels and strong support at lower levels. IE