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Educational Article

High Volatility as Opportunity

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I LOVE this market! Volatility remains incredibly high! That's good? You bet. Remember the old business saw about two shoe salesmen who go deep into the jungle on sales call? The first one returns demoralized and reports prospects are slim because nobody wears shoes. The second one returns waxing about unlimited possibilities. Why? Because nobody YET wears shoes! Same thing with volatility.

What's volatility? It's the measure of a stocks willingness, based on history, to experience fluctuation in price. The higher the volatility, the greater the magnitude of price fluctuation over a given period of time.

The volatility value isn't necessarily important. What is important for today's chat is the measure of volatility for the overall market - in this case, the VIX (INDEX:VIX.X), or OEX market volatility index.

In a market where confidence in market direction is high, the VIX should be falling. Isn't everyone convinced this is the beginning of a new bull market? Who in their right mind is still thinking, "bear market"? Didn't Dick Hoey, a frequent CNBC guest, tell viewers recently with steely-eyed confidence that we would be in a secular bull market by November 1st?

Our readers already know that this will be just another rally in a secular bear market. Option writers know this too, and what they are telling us through their actions, as indicated by a persistently high VIX is that they have no confidence in picking the market's direction right now. It could go either way. Thus, the premiums remain high - bad news if we want to buy options.

So do we then sit on the sidelines and wait for the VIX and premiums to fall? Heck no! We don't want to buy it. We want to SELL that juicy premium just like a regular option writer should!

I hope that doesn't sound scary to you. I'm not taking about religious trading by selling naked premium and praying to God it goes my way. I'm talking about one of my favorite things to do with options - selling expensive time premium, and letting it evaporate on the other guy with the passage of time. Time decay is as sure as the knowledge that the sun will rise in the East tomorrow - it's guaranteed to happen.

(Note: That is a guaranty that time value will decay; not that selling time premium will always be profitable)

But we can't just sell an option and walk away. It's safer and we have limited downside protection if we spread off the risk. In other words, for every short position we have a concurrent long option position to match just in case things go wrong.

"OK, that makes sense, Smarty Pants. But you can't just do that indiscriminately on any stock." No, I can't. . .which is why I'm interested in setting my entry parameters the same as if I wanted to enter a directional trade. I want technicals rolling out of an extreme oscillator position, and I want that to happen at points of support/resistance on the charts too. Let's take IBM as an example.

IBM chart - (daily/60/10):

Here's today's closing chart of IBM shown in daily/60 min/30 min form. Notice that the daily stochastic is rolling over having topped out at just over $75. We can see the candles topped at $75 on the 60 and 10 charts too. We can also see some secondary resistance at $73 too. However, the 60/10 stochastics are in oversold and looking to cycle up for a part of, if not the whole day tomorrow. Support comes in around $65. Are you getting the feeling that this might not make a good call entry? Support broken? Rolling stochastics on the daily chart? OK, this would make an attractive short. And it just so happens it's on the put play list starting tonight! Clearly, IBM has the earmarks of a stock that has peaked.

I might add that within the last 2 weeks, IBM received an upgrade from Lehman to Overweight; B of A upgraded to Buy; Merrill upgraded to Buy; Bear Stearns upgraded to Outperform; UBS Warburg reiterated a Strong Buy; and Solly reiterated its Outperform. That's it - bull up the stock after earnings so the brokerages can sell their shares into strength to their "preferred" clients. So as Fred Schwed wrote decades ago, "Where are the customers' yachts?" No worries. I'll save that for a rant some other day!

Back to IBM. . .yes, we could buy puts. But there's a large volatility premium in the price. What to do? How about a bear call spread?

Here's how it works. We sell a hugely inflated in-the-money (ITM) call option and simultaneously buy one slightly out-of-the-money (OTM) call for protection. Putting numbers to it, IBM closed today at $72.10. Knowing resistance is at $75, and knowing that if it ever breaks above that, it might mean a breakout to higher highs. We don't want to be short an even lower strike price call there. Thus, we would buy a $75 strike price call, say November, since time decay will work the fastest on inflated NOV strikes. Concurrently, in anticipation of IBM moving lower like the chart says, we'll short the $65 call, which currently has $7.10 of real intrinsic value ($72.10 - $65).

So here's the position:

IBM-KM NOV 65 = $8.10 bid - short
IBM-KO NOV 75 = $1.80 ask - long

Net credit = $6.30 in our pocket. That's the reward.

What happens to the price of those calls as the price of IBM sinks? They sink right along with it. Ideally, if IBM sinks to under $65 on or by expiration day, we keep the whole $6.30. Why? The buyer of the 65 strike will not exercise his option since he could buy the stock cheaper on the open market. By the same logic, we would not exercise our option to buy at $75 either. Both legs of the spread expire worthless.

Knowing that we have $6.30 in credit to our account, our break even would thus be at $71.30. We figure that by knowing that the 65 strike holder will exercise at any price above $65. To that we add our net credit of $6.30, which makes $71.30.

Any close under $71.30 on expiration day is profit. So if IBM closes at say $68, our profit would be as follows:

$65 - price at which shares are called
$68 - then current market price

Loss = $3

But remember, we took in a net credit of $6.30. When we apply the loss that happens upon the holder's exercise ($3), we still have a net credit at the end of the trade of $3.30! Still a nice reward!

We can't very well evaluate reward though without evaluating risk with at the same time.

What's the risk? Let's figure it out. We know that the breakeven is $71.30. Any amount over that at expiration starts costing us money. Specifically, every penny over $71.30 costs us a penny.

However, remember we have a long $75 call that gives us the right to buy IBM at $75. Every penny gain over $75.00 earns us a penny in option price. Our loss is maximized when IBM is at exactly $75 closing price on expiration. $75.00 - $71.30 = $3.70, which is our maximum loss.

The bottom line is that we risk $3.70 in order to gain $6.30. I like that ratio! And the charts are lining up in our favor.

But it gets even better. Not having yet entered the bear call spread in anticipation of an ultimate price decline, we have a chance to see if the 60/10-min stochastics can rise tomorrow back to overbought, which would, by definition might carry the price of IBM higher for a better bear call spread entry. That would have the effect of actually increasing our net credit on the spread the closer to $75 IBM gets.

That little secret is derived in knowing that the short ITM strike is gaining value dollar for dollar (delta = 100), while the long OTM strike won't rise as quickly until it becomes at-the-money (ATM). It's all about delta (and partially gamma). Ideally, if IBM was at exactly $75 today, we'd take in a $9.50 credit by shorting the NOV 65 call at $10.50 (guesstimate) and buying the NOV 75 call for $1.00 ($10.50 - $1.00 = $9.50).

Risk $0.50 to make $9.50? Absolutely!

So the next time the high volatility cost of buying a put gets you down, put the volatility to work in a bear call spread instead. For the veteran option traders, bull put spreads work well too when volatility is high. Just be sure the market is in a cyclical bullish phase (hint: check the weekly/daily stochastic).

Make a great weekend for yourselves!


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