Short Put Option Trading Example
For example, based on this assumption put sellers may have fared well during the lows in 2001, 2003 and 2007, and 2011. That is of course assuming that the option seller wasn't early in his entry. If a short volatility trader enters a market prematurely, there is a strong possibility that the trader will be forced out of the market prematurely due to lack of financing or margin. Let's take a look at one of the most opportune times in history to be a volatility seller (sell puts in the S&P).
Beginning in the middle of 2002 and throughout the beginning of 2003, put sellers with savvy timing may have done very well. However, trading is a game of risk and those selling puts during those times were accepting great amounts of risk in order to reap the reward.
Let's take a look at a continuous S&P 500 futures chart during the 2002/2003 lows. While the VIX is a great indication of volatility and extreme market sentiment, it is also helpful to look at indicators of volatility such as standard deviations. Luckily, the creation of Bollinger Bands allows us to visually determine market volatility through the line plot of two standard deviations from its mean. Times of high volatility are denoted by wider bands, or a larger standard deviation, and times of decreasing volatility result in narrowing bands.
As futures market volatility increases, so will option prices. During such times, commodity option buyers are forced to pay extremely high prices for options that in theory are more likely to expire worthless than not. On the other hand, option sellers are provided top dollar for accepting theoretically unlimited risk.