Steven Smith regularly writes for RealMoney, where this post originally appeared, and also writes 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 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.

One of the simplest and most straightforward ways for limiting risk is to use a married put strategy; that is, the purchase of put options in combination with buying or being long related stock or index product. In a recent article I used the

Financial Select Sector SPDR

(XLF) - Get Report


an example of establishing a married put. For those looking to start bottom-fishing at the financial sector, it might work something like this:

Let's assume you're looking at the XLF, which is currently trading around $30 a share. Let's assume you ultimately want to own 1,000 shares and plan to buy in three units every $1 down; that is, you buy 333 shares at $30, 333 at $29 and 334 at $28. This would give you an average price of $29.

A Safer Way to Play Financial Stocks

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For downside protection on those buys, you might look at the March $29 put, which currently has a

delta of 0.32, but will have a delta of 0.48 if XLF shares trade down to $28. At that point, you'd need about 20 puts to fully hedge your long position.

There are two approaches to getting into this downside protection. One, you could scale into the purchase of puts as you purchase the stock. That is, as you buy each 333-share lot, you buy the appropriate number of put options.

For example, if you bought the first third of the XLF position at $30 a share yesterday morning, to fully hedge it you'd need to buy around nine $28 puts. As the stock traded down to $29 and you bought another 333 shares, you'd need to buy an additional seven puts. Finally, at $28 a share, you'd need to buy a final four contracts to be fully hedged.

I'd rather go in and buy around 15-20 puts right off the bat, when I make the first purchase. Why? I assume I'll buy more stock at lower prices. By getting myself fully hedged from the beginning, the initial cost of the downside protection will be only marginally higher than the total cost of using a scale. Remember, as shares of XLF decline, the price of the puts will go up.

This leads to the important point that by purchasing the full slug of puts from the beginning, you're creating a position that is long gamma -- the position gets longer as shares rise, and actually gets shorter or more bearish as price declines -- meaning you can profit even if the share price of the equity you're involved with keeps declining.

I recently expanded on

how to define your risk profile and provided some resources for making adjustments and capitalizing on the opportunities presented during periods of increased volatility.

Use Spreads to Control Exposure

There are a lot of equations involved in figuring out the value of options, and it's important to be able to understand and distinguish each one's meaning and impact price. One example is that the terms "volatility" and "vega" are often loosely used interchangeably.

The lesson that has always stuck in my mind: While volatility, both implied and historical, represents an opportunity to make money, it is vega that actually represents money. That is, a position's vega is the measure that provides the actual dollar impact of the value of an option relative to changes in volatility.

Not to take this algebraic comparison to its obvious extreme, in which "money equals money," but I think it's worth pointing out that there is incredible overlap in which an increase in volatility does translate into more money.

The value of an option is based on several components -- the underlying stock price, time remaining to expiration, the strike price and even interest rates are all easily identified. The biggest variable, and the one hardest to pin down, is implied volatility. It is essentially the "answer" to price; whether you deem it accurate is immaterial, the price is the price. One of the keys to success in trading options is to control as many variables as possible. This helps you get a better control on risk and provides a more accurate expectation for profit.

One of the best ways to mitigate or control the impact of implied volatility or your vega risk is to use spread strategies. At the most basic level is a vertical spread, which involves the simultaneous purchase and sale of an equal number of contracts on the same underlying security that have the same expiration date but different strike prices. A impact rise or decline in IV will mostly be offset by the fact that you both are long and short similar options.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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