The CBOE Volatility Index () — one of the most-watched measures of
volatility and “investor fear gauge” — has come down from the record highs in
mid-October but is currently far above normal levels. This has translated into
a trading range of more than 500 points for the Dow () during eight of the
first 12 trading days in October.
What’s the reason behind this volatility spike? Certainly the turmoil
surrounding the Wall Street bailout and the credit crunch are factors, but
reports are also coming in that regulators are watching end-of-the-day trading
for signs of possible market manipulation.
Regardless, volatility is a fact of life in trading, but it doesn’t mean you
should stop trading. Here are five ways to use volatility to your advantage
right now.
Put Surprise Volatility to Work for You
So, how can you protect yourself when you are buying options in this volatile
market? Try buying options on stocks that have the greatest potential for
surprise volatility by looking for stocks that are particularly vulnerable to
surprise news or events.
Take a look at tech stocks, overvalued stocks with a lot of hype, single-drug
pharmacy stocks up for FDA review, stocks in industries that are in flux and
stocks with unpronounceable names.
The higher the volatility (that is, the higher the perceived risk), the greater
the premiums they will demand — and the bigger the profits you can make.
Catch the Draft From Expiring Options
Have you ever heard of “expiration plays?” These are short-term plays made
during the last week before expiration. Very close-to-the-money options traded
during this week can make dramatic moves in value very quickly.
The best “expiration plays” are index options, such as options on the S&P 100
Index (). The key to success in this strategy is to buy on weakness in the
option price.
In expiration plays, you are betting on surprise volatility swinging the price
of a stock or index — and, thus, the option — in your favor. Given the
current level of volatility, you certainly have the advantage now.
This trade has one caveat: You can incur a fair number of losses with this
strategy. However, just one big move in the index price can give you the
jackpot of a lifetime. (Try paper trading this idea to get a feel for the
results of this type of play.)
However, if a quick trade is not your style, don’t be afraid to take your time
with an options trade…
Give Yourself Time to be Right
Option buyers often complain that they never make as much money as they should.
This may be true, but the reason isn’t because the pros have conspired against
them; it’s because they’ve stacked the odds against themselves!
One of the biggest mistakes options traders make is they don’t give themselves
enough time to be right with a trade. Options as a wasting asset — not
perpetual investment instruments like stocks. The closer you get to expiration,
the faster the option price decays.
Option buyers who find they are frequent losers have stacked the odds against
themselves by buying near-term options that give them too little time to be
right. In most situations — unlike the previous example — I recommend giving
yourself 30 days or more to allow an option play to work in your favor.
Cover Me: Writing Covered Calls and Puts
If you’re holding equities in your stock portfolio, it’s likely that you’re in
a world of hurt right now. You can generate extra income — and give yourself
some insurance — by selling covered calls and puts on the stock.
You can sell covered calls on your stock if you believe the price is going to
rise or sell puts if you are feeling bearish. Let’s look at a covered call
example.
Suppose you sold options with a strike price equal to or greater than the price
you paid for the equity. If the stock remains flat, declines in value or even
increases a little, an at-the-money or out-of-the-money call will likely expire
worthless and you’ll keep the premium you received when you sold the calls. If
that happens, you can sell another covered call in a subsequent month.
If the stock appreciates above the strike price by the option expiration date,
your stock will likely be called away. This is not necessarily a bad thing. If
you sold at-the-money or out-of-the-money calls, you will generally make a
profit — possibly one that could exceed the profit you would have made had you
simply bought the stock outright.
Run With the Bears
It’s been difficult to guess the direction of the market from day to day, but
human nature tends to lean toward optimism, even as the market falls. Don’t let
that type of thinking cost you profits.
Sometimes the best-run companies and the strongest stocks get taken to task
during a panic period like right now. And there’s nothing wrong with buying
some put options on even the best companies when they’re going down — options
are not a permanent bet.
The beauty of trading options is that you can capitalize on the near-term
direction of a stock. Even if you’re absolutely certain that a stock price
would be going up under “normal” trading conditions, there’s nothing wrong with
making some quick profits if it unexpectedly moves in the “wrong” direction.
We’re sure your portfolio won’t mind.
