When Stocks Become Sinkholes

The position now controls 2,000 shares, double the existing long stock position between the price of $30 and $35 for no additional risk. Now, because the long stock and long calls are all covered, there is an equal number of $35 calls sold short, and the maximum profit is achieved and capped at $35 and above. Establishing the proper spread for even money can be a challenge, but high implied volatility, which usually occurs in the wake of a blowup, will help make the numbers more attractive.

Again, this strategy should be used as a means of reducing losses in a relatively short period of time, not completely eliminating them. Do not get bogged down by a CPR position. For a more complete explanation on how this strategy is constructed and works, please read this past article.

Picking Through the Rubble

When a stock blows up, the worst injuries are suffered by those who are short options or who have positions with a negative gamma. This is because the drop in stock price usually results in an immediate mushroom cloud of near-term implied volatility. But those who are clear of the implied volatility blast area can take advantage of some serious opportunities for profiting.

The usual play is to assume the move is overdone and look for bounce. This can be a very effective scalping technique, which Ken Wolff, a RealMoney contributor, describes as "playing the dumpers," but it requires exact entry and exit points, and a nimble trading touch.

One mistake many investors make is to use call options as the vehicle for catching the bounce. I do not believe this is the right approach. It may seem to limit your downside risk in case another bombshell falls, but in reality it leaves you exposed to a much more insidious sort of pain.