Embrace the Uncertainty With Tech Options

This article was originally published May 9 on RealMoney.com

OK, what now?

The market delivered a one-day move in the Nasdaq Wednesday that felt more like a flashback to 1999 than the reality of 2002. That leaves investors wondering if the rally indicates real strength or simply a one-day respite from pain and uncertainty.

It's a worthwhile debate with no answer -- simply because no one knows what's going to happen to the market, especially to beaten-down tech stocks. One strategist report Monday saw this rally coming based on negative tech coverage in this week's issue of Barron's. While that may be a little too technical for most of us -- I actually prefer emotionally wrenching past-life regressions to most market prognostication -- there's a prudent alternative to finding the right answer.

Go with the uncertainty. Play the uncertainty. Embrace the uncertainty. The opportunities to do this are rare, and we seem to have stumbled into one.

Straddles and Strangles

Options analyst Lillian Seidman of Miller Tabak said investors have a small window of time, but can move on such developments by using straddles and strangles. Simply put, some tech options prices have risen to the point where selling a combination of puts and calls while simultaneously buying the shares can generate a relatively safe, healthy return.

Seidman remembers the summer of 2000, when investors didn't want to dump their hefty tech-stock holdings and buy cheap options to replace them. That situation has been flipped on its head. Now the stocks are cheap and the options are expensive. Good options traders always try to sell the expensive asset and buy the cheap one.

In this case, the expensive asset would be the options. Tech-stock options have shown rising implied volatility -- the measure by which the market thinks the stock will move over the life of the option and a key ingredient to their prices -- for three days or so. So the market was expecting something; it's just that none of us knew exactly what.

So we straddle the fence. We buy Oracle (ORCL Quote) shares for $9.15. Then we sell the September at-the-money straddle, calls and puts, with a strike price of $10 for a combined $3. That's roughly a 32% return. You've defrayed how much you'll pay for the shares if the puts are assigned, and you've added to what you'd sell the shares for if the calls land in the money.

If Wednesday's performance was simply a relief rally and we're in for more pain, neither option will likely be assigned to you, and you'll keep the $3 and your Oracle shares for when things really turn around. If the wheels come off altogether, you could close the losing side of the position with capital taken in when you initiated the straddle.

Eyeing Opportunities

But this doesn't have to be done on such slim margins with at-the-money options. It's just that those typically have the richest premiums attached to them. You can instead opt for a strangle, which entails selling (or buying) puts and calls with the same expiration date but different out-of-the-money strike prices.

In this spot, we'd buy some newly inflated IBM (IBM Quote) shares at $82 and sell the July 85 call for $3.70 and the July 80 put at $3.50 to rake in $7.20, or almost 9%. If IBM sits, we're happy. But if it moves, at least we're dealing with a greater cushion until our options positions are in trouble.

Obviously, IBM's 8% move Wednesday makes this a tougher equation, but consider the premiums before the move and you'll see what spotting this kind of thing early can produce. IBM was trading at $76.35, and the October 75 straddle was going for $13.60. Again, the time for an IBM straddle or strangle may have passed, but there are other opportunities.

The idea here is that if you're not expecting a dramatic move in the market in the next three to six months, if you think Wednesday was a romantic peek at days past, it could be time to scan tech stocks, check out some options prices and embrace the uncertainty.