Cheap Stocks + High Volatility = Options Paradise

It remains a very confusing time for investors and traders alike. On Monday we saw prices cascade into the close. Yesterday we had what looked to me like a relief rally; others thought it might mark a bottom. In the past week or so I have seen bottom calls from people I admire; others I admire equally predict prices will go down another 20% from here. The financial press is full of people pointing at various chart patterns and fundamental indicators to support their market opinions. They are all guessing at this point.

I have said that valuations are making me cautiously bullish. That does not mean prices cannot drop further. There are too many unknowns and a few unknowables to accurately guess what this market will do in the weeks ahead. Earnings season is just starting, and it's reasonable to assume volatility will remain very high (as we have seen in the past several trading sessions). The hedge fund liquidation has seemingly abated for the moment, but we may see it again in November and early December. We still have tax-loss selling to deal with in the last two months of the year. The market reaction to the final election results is totally unknowable, as are the consequences of the various Fed and Treasury programs.

Let's look at what we do know. The precipitous decline in stock prices this year has created a lot of cheap stocks. We also know that volatility remains very high by any measure. Triple-digit moves up and down in the Dow are the norm these days. This volatility is reflected in options prices, and premiums are extraordinarily high right now. Traders can use the combination of cheap stocks and high option premiums to create trading opportunities as well as hedge existing positions.

Clearly selling puts on stocks you like a lot right now makes enormous sense. As always, I put up 100% margin and thereby cash-secure my short puts. With the wild swings we are seeing, posting minimum margins is quite likely to lead to a trader being carried out on his proverbial shield, run through by the always-deadly margin clerk.

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At the time of publication, Melvin had no positions in the stocks mentioned, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.