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Options Can Buy You a Little Safety

Less enlightened investors typically associate options with tremendous risk in much the same way your mother might, for example, associate the drop-dead gorgeous redhead you bring home for Christmas dinner with the possibility that you'll never want to see your family again.

Given this site's family orientation, I'll leave the risk-reward analysis of the latter to Maxim, but not before trying to dispel the notion that conventional wisdom is typically wrong, whether it's applied to options or potential mates. If this has been historically true of options, it is even more true today. The market is primed for investors to use options for the most safe and stable of purposes: reducing risk.

Identifying the Trend

Increasingly, over the past week or so, there has been more talk of married put plays -- buying a put against a long position -- than we've seen in a while. And while put-buying typically shows that investors are concerned about the market, the equity climate could be at one of those inflection points where put-buying is translating into the end of call-selling.

Admittedly, that may not seem like a big deal, but it could mean that investors don't want their upside potential constrained by selling calls. These days, any sign that investors even acknowledge an upside is a good deal. So, put-buying shows the desire to hold onto stock positions for the long term, creating a base of strong-handed investors for the market to build on.

One smart money manager I spoke to last week said he was cooling off his call-selling efforts because he felt the market was more likely to rise 50% in the next year than fall 50%. Now, that's not the sunniest prognosis, but it's a start.

On Wednesday, Scott Fullman, the options strategist at Swiss American Securities, recommended a married put play on Medtronic (MDT - Get Report), suggesting buying the stock (around $46 at the time) and the August 45 puts.

The stock has shown a little pop in the past few weeks, so the smart play is to try to ride it out, but with a little protection in your pocket.

Examining ETFs

Mike Schwartz, a senior options strategist, is spending much of his time trying to figure out how to pair options with exchange-traded funds for risk-averse investing.

Enron vs. ETF
The Energy SPDR fares much better than Enron shares.

"Using ETFs is the ultimate reduction of single-stock risk," he told me Wednesday morning. (For an example of ETF safety, take a look at a six-month chart comparing the delisted Enron to Energy SPDRs (XLE). The ETF was essentially flat as the Enron shares disappeared into the abyss.)

Schwartz said he's looking at using covered calls, short-term puts and long-term married puts on the ETFs for clients who want to get long, but in a more secure method. This conversation took place only a few days after the Chicago Board Options Exchange had a Marilyn Monroe impersonator singing "Diamonds Are a Girl's Best Friend" to celebrate the launch of its trading of options on the Dow 30 ETF.

Even some of the more recent speculative activity has been focused on puts. This week, stocks such as Abercrombie & Fitch (ANF), Toys R Us (TOY), Starwood Hotels (HOT) and Adobe (ADBE) saw above-average put volume. That means that speculators who smell moves are coming back into the market to pick their spots; they're not just clinging to the potential for broad market weakness.

Merger speculators must have offered up sacrifices to the investment banking gods this week as their bets on a takeover bid for Golden State Bancorp (GSB - Get Report) came through Tuesday. The buyer was Citigroup (C - Get Report).

Call options activity percolated for three days leading into the announcement, with little hint of what was actually shaking out. On Tuesday, before the news was released in a post-close announcement, Golden State call options showed volume of 1,400 contracts, compared with an average total volume of 319.
Dan Colarusso is a New York-based financial writer. His recent work has appeared in The New York Times, Barron's, Institutional Investor and Investment Dealers' Digest. At time of publication, he held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Colarusso welcomes your feedback.

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