Over the last few sessions, the major stock indices have seen some wild price swings and expanding daily trading ranges. The threatening breakdown in stock prices coupled with the dramatic rise in interest rates is causing a growing perception among investors that market risk has increased. In the options market, this is reflected by a marked rise in the volatility index, or the VIX.
After hitting an 18-month low last week, the popular gauge has shot up some 20%. But at around 24%, the VIX is still at the low end of its normal trading range and, more importantly, it may not reflect accurately whether options on specific stocks are cheap or expensive. Only by measuring an individual option's current implied volatility vs. its historical volatility can one assess its relative price. This will help determine the best strategy when trying to establish both bullish and bearish positions.
Options Still Offer Value
I ran a scan looking for stocks whose current implied volatility was within 5% of its one-year historical low and within the bottom 20% of its two-year historical average. Because we're just emerging from a very narrow two-month trading range, I had a feeling there would be some bargains out there. And if we truly are entering a period of rising volatility, I want the wind at my back in terms of being net long premium and gamma. It would also follow that given the accompanying rise in market risk, being long options, whether puts or calls, will define and limit my risk.
I took my list and started scrolling through the charts to identify candidates that offer favorable risk/reward scenarios, i.e., the technical picture provides definitive entry, exit and stop prices. By using a well-defined trade with the leverage and limited exposure of long options, I'll have gone a long way toward reducing my risk while maintaining a meaningful profit potential.
First up is
, the watch and fashion accessory company, which has done a nice job distributing and licensing its products. The company's been showing low double-digit earnings growth over the past three years and earnings per share are expected to increase by 18% this quarter. The chart is showing a nice bullish wedge with good support at $25.
Given the potential for market-moving news next week -- the company is scheduled to announce quarterly earnings on Tuesday -- buying a relatively short-dated at-the-money call is an appropriate strategy. With the stock trading at $25.30, the Sept. 25 call can be purchased for $1.50. If Fossil provides positive guidance, the shares could leg up sharply. The September date also provides enough time for potential good news regarding Labor Day and back-to-school sales to work the share price higher. If the earnings disappoint, then the $25 level will quickly be broken, setting off our mental stop. Our maximum loss can be $150 a call, but most likely it would be less.
is a diversified company with businesses ranging from health care to funeral home industries (that's either tremendous conflict of interest or genius synergy).
The two points that drew my attention to Hillenbrand is its large double-top at $54.80 and that the current implied volatility in its options is at the low-18% level -- its lowest level in 18 months and more than a 50% reduction from the spike to implied volatility of 38% in January. Even though the downside may be limited to some support at $50, I'll still opt to buy puts rather than sell calls, due to the low volatility.
With Hillenbrand's shares trading at $53.80, I can buy the December 55/50 put spread for a net debit of $2. This looks like a good value given the spread already has $1.20 of intrinsic value and more than four months remaining. My maximum loss is just $2, while the maximum profit is $3 a spread. By comparison, a naked sale of the December 55 call would net only $1.50 credit while exposing us to an unlimited loss.
Hitting a Top?
appears poised to be a big beneficiary of a growing defense budget. The stock recently gapped up, breaking a long downtrend, and now has good support around $88.
Ready to Fly?
Due to my bullishness on the stock and its costly low-$90s price tag, this is a perfect candidate for buying Long-Term Equity Anticipation Securities, or LEAPS. The purchase of LEAPS calls not only cuts my risk to the option's price but also ties up significantly less capital than holding shares of the underlying stock for the next year.
With the stock trading at $90, the January 2005 95 call can be purchased for $8.50. The implied volatility on that strike is just 21% -- well off the one-year historical average of nearly 31%. A mental stop of a close below $80 can be used as a trigger for selling out the call. Depending on the time remaining, any loss incurred would be significantly less than the $10 you would have suffered had you owned the underlying shares. On the upside, your break-even level is $103.50, and of course, the profit potential is unlimited.
Steven Smith writes regularly for TheStreet.com. 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 invites you to send your feedback to