Options Investing: Don’t buy, sell
Today's Financial News - Posted November 17, 2008
Volatility remains at ultra-high levels. It has forced investors to change the way they make their profits. Smart investors are turning to unique options strategies to increase their income streams.
By Andrew Snyder, TodaysFinancialNews.com
Baltimore – (TFN): Let’s face it. The stock market has been more than a bit manic-depressive lately. The ups and downs of wild daily swings are more than enough to force nauseous investors to binge on handfuls of Prozac.
The markets are making gyrations unlike any other time in history. Since 1929, the equities market has witnessed intraday volatility of over 8% just 64 times. That means the swing from the daily low to the daily high was over 8% just over five dozen times during a span of more than 20,000 trading days.
To prove just how volatile the market has been in the last two months, 14 of those 64 days were recorded since late September of this year. The crash of 1929 saw just eight days with that kind of volatility. Investors in 1987 saw just four days. And during the bear market starting in 2000, we saw only two occurrences. We are in an unprecedentedly vicious market.
There is little doubt that we will see even more ultra-high volatility days as the current crisis flushes itself out.
Volatility at its peak
With volatility-measuring indices like the VIX reaching all-time highs, it is no wonder many investors are running in fear. The markets are re-testing bear-market lows and with implied volatility (the measure we use to gauge options premiums) at more than twice historical averages, investors have few traditional means of finding protection.
Normally, one of the simplest ways to protect from a market downfall is to buy put options against a major index like the S&P 500. As the index falls, the option’s value increases and the investor profits handsomely.
Unfortunately, that simple approach is out of the question as options prices are soaring. As I write, the implied volatility of S&P 500 December 800 puts (SPXXT) is over 63%, which is extremely high and shows a strong bearish sentiment.
At the option’s current price of about 39, the S&P 500 would have to drop below 761 (the 800 strike price minus the 39 premium) before mid-December or volatility would have to increase even further (increasing the implied volatility premium) for the options contract to start paying off.
These figures prove that options are in high demand as the market makes its wild moves.
It makes sense that investors are looking for insurance and protection from a gyrating market. But it does not make sense to pay these outrageous premiums. So what is an investor to do?
Sell, sell, sell
For an answer, we need to turn back to Econ 101. Remember, when demand outstrips supply, prices rise and the folks selling a product profit handsomely. The same rules apply in the options market.
Many novice investors do not realize it, but anybody can sell options.
With derivative prices selling at levels we have never seen before, it makes sense to turn from buying options to selling them. Instead of buying outrageously expensive insurance for your portfolio, sell the insurance policy and protect your investments by adding a profitable income stream.
As I said, S&P 500 puts are selling for huge premiums. If you were the one selling the contract I mentioned above, you could pocket gains as long as the popular index does not drop below 760.
If you are not willing to sell puts in a hugely bearish market, with their large downside risk, you could sell call options. They still have an unlimited downside if share prices suddenly make hugely bullish surges, but with today’s historically large premiums, the reward certainly outweighs the risk. With the S&P 500 December 900 puts (SXBLT) trading for 43, the index would have to make a large turnaround before the profit potential disappears.
But savvy investors will not make just one investment and expect it to adequately protect their wealth during this downturn. The smart investors will use a host of tools like straddle plays (a great way to profit from volatility) and covered calls and puts to create a portfolio that can weather even the worst financial hurricanes and puts time decay (the phenomenon that lowers the intrinsic price of an option as its expiration date closes in) in their favor.
Over the next few weeks, I will delve more into these strategies that too often are classified as “sophisticated” tools reserved for only the most schooled traders. With today’s electronic trading technology, any investor can make all of the investments I mentioned.
My goal is to prove it to you so you can continue to invest and make money during this economic calamity. You will like what you see.
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