How You Can Profit From High Volatility

Editor's note: This was originally published in two parts on RealMoney. It is being republished as one article as a bonus for TheStreet.com readers.

High-Volatility Investing, Part 1: Avoiding High Anxiety in Times of High Volatility

When the market resembles a jar of jumping beans, substituting call options can lower downside risk.

It is a familiar story these days. You have pretty demanding criteria for new positions, but you do some research and find a stock that meets them. Despite your care, the stock tanks.

When the market is making huge daily moves with little fresh information, investors need special tactics. In a series of articles, I am going to suggest ideas for dealing with high volatility and some stocks that fit the bill. The following strategy should be considered an alternative for any investment where you like the stock but recognize downside risk and high implied option volatility.

For our purposes, assume your candidate is undervalued (in both absolute terms and relative to the market) and exhibiting a lot of volatility -- making big swings in line with the major indices. For example, Caterpillar (CAT Quote) has been a popular pick on the site and I like it a lot. The normalized earnings growth rate is good, the company is practicing cost containment and plenty of orders are already booked.

However, the trading range is difficult to determine. For Caterpillar believers, the recent price is already outside the range. When a sound bottom cannot be identified, it is more important than ever to address downside risk. In a market where some cyclical stocks trade at one or two times earnings, there is plenty of risk. Substituting call options for a stock can be a good method to limit downside risk.

To make the example easier to follow, I will start with the answer and review the process. The recommended position is the purchase of the Jan 30 call at a price of $8.70 and the sale of a Dec 40 call for $1.42. The prices given are all real at the time of writing, with the stock trading at $37.00. (By the time you read this, the exact prices will have changed, but the illustration is still valid.)