How to Handle the Volatility With Options

Steven Smith regularly writes for RealMoney, where this post originally appeared, and also writes TheStreet.com Options Alerts.

As the debate rages over the economy and all the associated issues -- housing, interest rates, consumer spending, inflation -- and as we figure out how all the pieces fit together and will play out, one thing we can agree on is that volatility is definitely on the rise, probably due to the aforementioned cross-currents.

So far this year, the VIX, which measures the implied volatility of S&P 500 index options and is the de facto measure of perception of broad market risk, had been trending higher. It hit a four-year high of 36 on Aug. 16, and despite its retreat of some 27% to around 25, it is still about 80% higher for the year to date.

This increase in implied volatility (IV) or risk premium is in large part simply a reflection of the reality that the real or historical volatility (HV) of the index and individual stocks has increased dramatically this year. For a graphic comparison of HV and IV for the S&P 500 index, take a look at this page on iVolatility.com. As you can see, the IV has basically tracked the HV all year. The question is, how does one deal with this increase in volatility?

Risk or Opportunity?

As I've discussed in past, the prudent way to approach trading or even long-term investing is to adhere to the mantra that "defense wins championships." That means that the first step in establishing a trade or building a position should be focused on the risk part of the equation rather than potential gains

Options get a bad rap as a risky investment product because too many people focus on the leverage that can provide unlimited profit potential. The reality is that options and their leverage were originally created as risk-management tools or ways to buy insurance.

The other reality is one never realizes an unlimited profit -- that is a complete siren song -- and one should have reasonable expectations for taking profits. That means entering each position with well-defined risk/reward parameters, which becomes especially important during periods of increased volatility.