Fear and Loathing in the Options Market

Spreading the Risk

For traders looking to use options as nature intended -- namely as hedges within a portfolio of stocks -- Overby says a prevalent strategy is to use bear put spreads using index options or in large-cap index components that exhibit a high level of correlation with the broader index.

"Buying a put that's either at-the-money, or, to save a little money, 5% out-of-the-money, and pairing it with the sale of a put another 20% below that strike still gives you some downside protection and allows you to take advantage of the current implied volatility skew to puts," says Overby.

Buying bear put spreads, as opposed to buying naked or protective puts, also limits the potential profit of the transaction, because the long higher-strike put is hedged with a short, deeper out-of-the-money put on which the trader may be exercised if the underlying stock price falls below that lower strike.

And while many speculative directional or volatility plays have likewise become too costly, Overby suggests putting a directional bias on a traditionally neutral strategy, such as a butterfly, in order to express a bullish or bearish view on an underlying stock. A butterfly involves the sale of two options against the purchase of one higher strike option and one lower strike option, with the trader looking for the share price to settle at the middle strike.

"If you're really a directional player, an out-of-the-money or directional butterfly is an interesting strategy to try, because it's basically a volatility play that can express a directional view depending on where the trader places the middle strike. If the middle strike is above the current stock price it is bullish, if below make it bearish. A butterfly is especially interesting from the upside because you want volatility to come down, which will invariably happen if the market moves higher - and using a butterfly strategy instead of a naked call will keep that trader from getting crunched by volatility," he explains.

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