The Striking Price

Playing a Market Near Its Highs

STEVEN M. SEARS

Saturday, April 5, 2014

U.S. investors now face pricey stocks and cloudy economic data. Here are options strategies on stocks and volatility to profit from the situation.

Last Wednesday, when stocks were pushing toward record highs and Wall Street was ebullient, Christine Lagarde was doing her best rendition of a world traveler suffering from mild depression.

At a speech at Johns Hopkins University, Lagarde, the head of the International Monetary Fund, noted that "the global economy is turning the corner of the Great Recession, although overall growth remains too slow and weak." She warned that developed economies have growth challenges and emerging markets face volatility. The Ukraine crisis, if not managed well, she added, is another dark shadow.

Her remarks are a reminder of risks U.S. investors confront with the market dancing around all-time highs and economic reports suggesting an anemic, volatile recovery. She did not mention the imminent U.S. first-quarter earnings season, though it's worth noting that few events can reshape investment sentiment like earnings reports and corporate outlooks.

The time is thus propitious to swap high-priced stocks for lower-priced call options. Many options are trading without greed premiums due to the peculiarity of options-pricing models, so investors can sell high in the stock market and buy low in the options market. The stock-replacement strategy lets investors participate in future stock advances while minimizing money at risk. Call options cost a fraction of stocks.

The stock-replacement trade is probably the easiest options-trading strategy around. Just sell the stock and buy a call with a strike price that matches or is slightly higher than the associated stock price. Consider calls that expire in January.

Should the stock, or broad market, decline on feeble economic data or stock-specific news, investors will be in a position to buy back at a lower price during the decline what they sold higher during the rally. Though call owners do not receive ordinary dividends, calls do offer leveraged participation in stock advances.

To contextualize the view of sophisticated investors toward the stock market, review positioning in the CBOE Volatility Index (VIX) that tracks the Standard & Poor's 500 index put-and-call options. On Wednesday, the VIX fell to 12.93, a level suggesting investors have nary a care that stock prices are at record highs. The VIX last fell below 13 on Jan. 22, when Wall Street was filled with the feel-good forecasts of a new year.

SOME INVESTORS, HOWEVER, know that volatility behaves like a metronome, and that fortunes have been won by hedging stocks when VIX is low and options are relatively cheap, and buying stocks when VIX is high and stock prices are low. On Wednesday, when VIX was dancing around its lowest levels of 2014, an investor bought 30,000 VIX May 16 calls and sold the same number of VIX May 26 calls. These trades have largely been money-losers this year, but Ben Londergan, who runs Group1, a VIX specialist firm, opined that portfolio managers are simply being responsible and hedging portfolios when stocks are at record levels. If they gave up their gains at that point, they would look silly and face the wrath of their investors.

Of course, some investors, perhaps the same ones buying VIX calls, are playing the other side of the volatility metronome. They are buying VIX puts to position for volatility to ebb, which would occur if stocks keep advancing. The "baby puts" cost five cents to 10 cents and expire in the summer when not much happens in the markets with investors on vacation.

Stock market corrections are likely to be short and shallow. Economic data are uneven and grudgingly improving. Companies are gaining traction. If you want, you can just listen to the tick tock of the VIX, but of course there is always something delightful when you make money selling high in one market and buying low in another.

Reprinted by permission of Barron's Online, © 2014 Dow Jones & Company, Inc. All Rights Reserved Worldwide.

The views expressed in the above papers and articles are solely those of the author of the article, and do not necessarily reflect the views of OIC; the information presented is not intended to constitute investment advice or recommendations to purchase or sell securities of any company; and the information presented is based upon particular events that may or may not recur in the future.

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