Resolving to Remember the Value of Options

When options are cheap, portfolio insurance or hedging positions through the purchase of put options becomes less expensive and increasingly attractive. Call options can be bought to replace long stock holdings to lock in profits and maintain a bullish position but reduce risk. Straddles can be purchased that only need a small percentage price move in either direction to become profitable.

The bottom line is that what this year's decline in implied volatility has taken away in terms of price decay, it has given back by providing more leverage through cheap option prices.

Time Moves Forward

Einstein's space and time theories aside, one of the few things traders can count on is that the valuation of an option will contract at an accelerated rate over time. One strategy that takes great advantage of time decay, and has been one of the most effective this year, has been calendar spreads, also known as time spreads, which involve buying a long-dated option and simultaneously selling a shorter-dated option. Over the past year I've suggested calendar spreads in gold, homebuilders and defense stocks. Call it theta, call it shrinkage, call it whatever you want, but understand it and use it to your advantage.

One reason calendar spreads have been so effective in 2003 is that they are an efficient way to establish a limited risk position while minimizing the cost basis. This past year of having stocks and the overall market moving in a steady direction with low volatility is a custom fit for time spreads. I think such spread strategies can continue to be successfully employed on a selective basis in 2004 by both traders and investors.