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Traders Hunt Post-Christmas Bargains in Options Market

With the mergers and acquisitions market cooling in late 2000, options traders seeking other ways to score large moves in an uncertain market have turned to finding placid stocks and cheap options that have the potential for big moves.

Volatility Index
Today % Change
32.09 -0.68
Source: ILX
Those stocks, however, are harder to find in an environment where the implied volatility of options -- the measure of how much the market thinks a stock may move -- is skewing higher than usual. The Chicago Board Options Exchange Volatility Index is currently at 32, closer to its 52-week high of 41 than the low of 16. High implied volatility translates into higher options prices, especially in stocks investors consider vulnerable.

Put/Call Ratio
Today (12:00 p.m.) Previous Close
0.47 0.68
Source: ILX
Michele Skupp, of Miller Tabak's Seidman Skupp options team, says she's been watching low-volatility stocks, such as those in the natural gas and thrift sectors, more closely in the past few months. "We always watch for low volatility," said Skupp, who's also highly regarded for catching M&A hints from the options market. "But this is the year it worked."

The key to finding these kinds of options plays is finding stocks "no one thinks will ever go down," Skupp said. "Natural gas stocks are a good example. They've performed well, but there could be an event" in the world markets that adds uncertainty to the sector. That uncertainty will drive options prices higher.

The difference to an investor can be huge. When trading options, investors can be right about a certain event -- such as an earnings warning -- but if that uncertainty is built into the option's price before it happens, the pop on the actual news often will be less.

Some of the names that have been showing up on her watch list are natural gas companies Apache (APA) and Enron (EOG), and thrifts such as Greenpoint (GPT) and Washington Mutual (WM).

While determining low implied volatility may be beyond the average investor's ability, watching the prices of at-the-money options is always a key. Because an option's price is determined mostly by the amount by which it is in-the-money, the time remaining in the contract's life, and the implied volatility, at-the-money option prices can determine how big a portion volatility accounts for.

For instance, with Greenpoint trading at $40.50 Thursday, its January 40 calls were trading at 1 3/8 ($137.50). Contrast that reading to a company such as Brocade (BRCD), which has seen massive call buying during the past few days. Brocade was trading up $3.56 to $92.44 this morning and its January 95 calls cost 7 3/8 ($737.50).

It's no different with puts. At-the-money puts on Apache, which was down 25 cents to $71.56 this morning, were trading at 2 3/4 ($275). Brocade's at-the-money puts cost 7 3/4 ($775), showing that traders had turned up the volatility reading to get compensated for the risk of the stock falling through that $90 strike price. Market makers, who adjust the volatility levels on stocks based on demand and other parameters, didn't seem as worried about Apache's chances of dipping through the $70 strike price. It's not always that simple but it's a good starting point.

To Skupp, it's worth the chance to grab bargains at this point in the market. "In the current conditions and with Reg FD (the Securities and Exchange Commission's Regulation Fair Disclosure) there are going to be surprises," she said. "We try to be positioned for them."

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