Avoiding High Anxiety in Times of High Volatility, Part 1

I usually look for a deep call two to four months out. When buying this type of call, there are several things to look for.

• The strike price is the price at which the call holder has the right to buy the stock. For a stock substitute position, I look for deep in-the-money calls, which means the strike price is below the current stock price -- usually significantly lower. In the case of Caterpillar, the call is seven points in the money.

• The call delta is the expected change in the price of the option relative to the change in the price of the stock based on option pricing models like Black-Scholes. In a deep call -- one that is significantly in-the-money -- I can usually find a delta of 80 or so, which means if the stock price moves up by 1 basis point, the call value should increase by 80 cents.

• The option premium is the difference between the option price and the intrinsic value, also the difference between the stock price and the strike price. In our example, the Jan 30 call is priced at $8.70. If you add the strike price to the call price, you get $38.70, which is $1.70 over the stock price of $37.00. That is your option premium. If you just buy calls, you will eventually pay this premium for the advantage of reduced risk. When expected volatility is high, this price can be very steep.

• Selling a call. By selling the near-term Dec 40 call for $1.42, you recover most of the option premium.

• Position size is a crucial element. Suppose that your normal position would be 1,000 shares of CAT at $37, a total outlay of $37,000. When substituting calls, you should not spend the same dollar amount; if you did, your risk would be much greater. An equivalent position would be about 15 to 20 calls. If you bought 15 Jan 30 calls and sold 15 Dec 40s, your outlay would be about $13,000 for the call purchase less about $2000 for the call sale, for a net expenditure of $11,000. The difference of $26,000 should be held in a safe, interest-bearing account. If you invest your entire position in calls, your risk is too great.

The key advantage of this position is downside protection: If the stock pulls back rapidly, the deltas in your long call will decline, cushioning your loss. The implied volatility will expand, also increasing the call value. Even if the stock declined to $33, your long calls would still be worth more than $5 given the increase in volatility. Briefly put, your absolute risk of loss is dramatically reduced; your practical risk is even lower.

The trade has plenty of upside gain. If the stock rallies to $40 or above before the December expiration, you make $3.00 minus the difference in call premiums, 28 cents. This is a gain of $2.72 times 15 calls, or a total of nearly $4,100 in a few weeks, a nice return on your $11,000. If the stock treads water, or rises slowly, you pocket the premium from the call you sold and have the opportunity to sell a January call or reset the entire trade.

Volatility pops when the stock declines and shrinks when it moves higher. During part of Wednesday's trading, I was actually showing a gain on both my long and short calls as the Caterpillar rose. The implied volatility in the short call was coming out so fast that the option was losing value even with the stock price increasing. Let that be a warning to those who buy near-term out-of-the money options when volatility is high.

Consider limiting risk by buying a deep call as a stock substitute. You can also sell a front month out-of-the-money call with a fat premium that will disappear rapidly. The combination gives you a very reasonable upside play with excellent downside protection, and compares favorably to buying calls and paying a big premium.

Know What You Own: Caterpillar operates in the farm and construction machinery industry; other stocks in this field include Hitachi (HIT - commentary - Cramer's Take), Deere & Co. (DE - commentary - Cramer's Take), CNH Global (CNH - commentary - Cramer's Take), Joy Global (JOYG - commentary - Cramer's Take), ACGO Corp. (AG - commentary - Cramer's Take) and Bucyrus International (BUCY - commentary - Cramer's Take).

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At the time of publication, Miller was long CAT, although positions may change at any time. Jeffrey Miller is president and CEO of NewArc Investments, a registered investment adviser, and Capital Markets Research.

Miller writes about the market, interpreting data, and finding the right expert at his blog, "A Dash of Insight. He is writing about the 2008 presidential campaign and the implications for individual stocks and the market at Election Stocks. His investment company, with programs for both individual and institutional investors, is NewArc Investments.

Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Miller appreciates your feedback; click here to send him an email.