The Striking Price

How to Play a Chaotic Market

STEVEN M. SEARS

Saturday, October 25, 2014

A "risk-reversal" strategy can pay off when volatility rules.

For an endeavor that requires making just one of two choices, investing is surprisingly complex. That such intense analysis and debate are applied to determining whether securities should be bought or sold would be comical were it not for the fact that the cumulative outcome of these decisions influences the world.

For several weeks, investors have anxiously tried to decide whether they should buy or sell. The binomial ballet pushed stock prices sharply lower, then sharply higher, and now they're in a queasy, jumpy pattern. Another week has ended, and the proper decision is not much clearer. The charts of the Standard & Poor's 500 and the CBOE Volatility Index (VIX) increasingly resemble Rorschach tests. What you see says more about you than it does about the market.

THUS, CONDITIONS ARE IDEAL for options trading. Using puts and calls lets you buy without really buying and sell without immediately selling. These outcomes are possible because implied volatility, the essence of options prices, is sharply elevated now, reflecting what Joseph de la Vega, the spiritual father of derivatives trading, termed the confusion of confusions in 1688.

While the S&P 500 rebounded quite nicely last week, at one point rising some 6% from the previous week's intraday low, its 90-day implied volatility is near two-year annual highs. This reflects anticipation of a sharp move. Unfortunately, volatility doesn't reveal direction, but every investor tends to have a view on what's ahead for his or her stocks.

Chris Jacobson, Susquehanna Financial Group's derivatives strategist, suggests taking advantage of options' heightened prices, which indicate widespread fear, by selling calls against positions. "For investors who believe a dramatic further move higher into year-end is unlikely, the increase in volatility can provide for attractive overwriting opportunities against an entire position, or a portion of a position," Jacobson recently advised clients.

The strategy balances the risk that stocks will sink against the prospect of a big rally. Should prices fall, the investor keeps the money received for selling calls, which will offset some of the stock's decline. Should the market advance, pushing the stock above the call's strike price, investors also keep the premium, but must sell their shares.

Most investors overwrite positions by selling options that expire in three months, because the 90-day expiration cycle tends to be the most liquid, or actively traded. Overwriters often pick calls with strike prices 5% to 10% above the stock's price, hoping to participate in another rally.

For example, when Corning (ticker: GLW) recently was near $17, investors sold 7,000 October 19 calls that expire on Oct. 31 to collect 23 cents per option. In CBS (CBS), they sold 8,000 November 58 calls at 65 cents when the stock was near $53.

Investors who want to buy into market weakness can play the put side. Jim Strugger, MKM Partners' derivatives strategist, is advising clients to sell puts and buy calls. This risk-reversal strategy takes advantage of puts' current high implied volatility, reflecting fear that stocks will soon tank again, perhaps ending the bull market.

STRUGGER LIKES RISK REVERSALS on Baker Hughes (BHI). The energy stock is down almost 21% from the September S&P 500 high, and that has elevated three-month skew (the difference between put and call implied volatility) to the 97th percentile. Strugger likes selling Baker Hughes January 45 puts and buying January 62.5 calls. When the trade was modeled, the position was initiated without cost, as the puts and call were trading at the same price.

Bottom line: Paralysis by analysis is the enemy of decision-making. Sometimes, a well-placed put or call can create a tradable pattern out of the market's chaos.

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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