Nasdaq Options Players Not Too Proud to Hedge

Put-buying in one Nasdaq measure shows at least a little concern for the leading OTC names.
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The awe-inspiring

Nasdaq

index has detached itself from the rest of the market here on Earth. And for investors, that means Nasdaq option plays are becoming prohibitively expensive.

Some traders, however, seem willing to pay the price for Nasdaq index put options, which serve as protection if profit-taking begins in earnest or some negative factor hits the market.

It's rare that the volatility in the Nasdaq unit trusts -- which trade under the symbol

QQQ

and are one of the most popular option contracts around -- climbs so much more than some of the individual names that make it up.

But that's what's happening. And it means that for the average investor, Nasdaq options aren't the place to find a cheap proxy to play the sector's strength -- at least not this week, with the QQQ currently trading at 160.37, up 0.57 at midday.

Options get expensive because the traders on the exchange floors who provide the market for them think it's too risky to sell them at certain prices. The vols rise along with blood-pressure levels and half-smoked Marlboros but, unfortunately for individual investors, have a greater impact on prices.

On the floor, the thinking behind volatility goes like this:

How much is this stock going to move, up or down, on an annualized basis? And if I don't price in enough volatility, am I going to get screwed by trading these options at all to account for the risk?

Investors should be thinking the opposite.

Is this option's price built more on this implied volatility than on the strength of its underlying? And what kind of move will it take to make it worthwhile?

"This bidding up of Nasdaq has occurred from mid-November to now, and during that time it's blown past the

Standard & Poor's

" index, notes Michael Kelly, head of

Onyx Capital Management

, a New York hedge fund specializing in options trading.

And the volatility of QQQ options, for instance, has spiked to the low 90s, up from a historical level of between 30 and 40.

That factor was likely a major contributor, as investors seemed to put most of their QQQ options plays in the hedging category as they chased individual names in the straight equity.

Among the most active of the Nasdaq options were the December 158 puts, which had traded more than 7,800 contracts, compared with open interest of 5,090. December 158 puts were trading for 2 5/8 ($262.50), down 3/8 ($37.50).

Options in

Microsoft

(MSFT) - Get Report

, however, one of the biggest components in the Nasdaq, are priced using a volatility "somewhere in the 30s," Kelly says.

Kelly's advice? "Rather than trying to speculate on the big move in the Nasdaq, play an individual name instead of the index." Volatility -- that is, the "fear" factored into the price of Nasdaq options -- is simply too high. "You'd be paying out the nose," he explains.

The momentum stocks, meanwhile, are exhibiting some of the same characteristics as the Nasdaq, he adds. "We generally stay away from options in these stocks. It's just too dangerous to make a bet either way."

Despite the climb and signs in the equity market that momentum investors are flying blind, there are indications that some are approaching their stocks with caution.

For instance, open interest in the out-of-the-money December 150 puts stood at about 12,300 contracts, indicating that a sort of "wall or worry" has built up ahead of next week's expiration. Often a heavy concentration in the puts indicates that investors are piling in for some downside protection.

So far, January's looking similar, but it could turn even as quickly as next week. The largest open interest so far is in the 2000 January 150 puts, at slightly more than 3,000 contracts. Those options were trading for 4 3/4 ($475), down 1/4 ($25) at midday Wednesday.

A coda to those numbers, though: Remember, the QQQ is a smoke signal of sentiment for

retail

investors. Why? People who buy QQQ options generally are retail investors, as it's not necessary to have a futures account open to hedge against those positions.