When Stocks Become Sinkholes

Just as the initial move creates that burst of volatility, the fallout in the days immediately following a blowup are usually characterized by a slow drip or decrease in options value as volatilities return to a more normalized level. Buying options the day after a blowup is akin to holding a radiated material with a quick half-life: It could certainly come back to life, but it's more likely you'll experience some serious premium decay.

If you are looking for a bounce, a better bet would be to sell put options. This strategy takes advantage of both the increased implied volatility and the fact that the stock needs to only stabilize, not necessarily rally, for the position to yield a profit.

Kicking Dirt in the Hole

A completely different approach I used to take, and one Street Insight contributor Adam Warner employs, is to sell calls on the morning a stock blows up. The reasoning behind this is straightforward. You are once again taking advantage of inflated option premiums, and usually a stock will take some time before mounting a sustainable rally after a blowup. So even if the stock does get a small bounce in the day or two after the initial decline, the options will usually see a commensurate decrease in the implied volatility, which should keep any losses to a minimum.

A rule of thumb used by Warner is to use the first day's high as a mental stop; if the stock trades above that day's opening range, he will close the position. Selling calls after a stock has cratered may only offer limited gains, but the percentage of profitability is fairly high. It follows Jim Cramer's rule to wait 30 days after a blowup before even contemplating buying the stock.

When stocks blow up, the best attitude to take, no matter what your opinion on the company, is that it will take time for prices to normalize, but normalize they will. In the meantime, avoid buying options with overly inflated prices.