Options Pros Advise Against Following the Herd Today

Suggested reforms in the financial, banking and insurance sectors have sent the Philadelphia Bank Index soaring.
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Take some advice from options players: Avoid the pack mentality, and do not do as the Romans do.

There were rumors all over Wall Street late this week, encompassing takeover chatter and general trend-riding in

Steris

(STE) - Get Report

,

Spyglass

(SPYG) - Get Report

and insurance companies potentially freed from restrictions of that great anachronism, the

Glass-Steagall Act

. (

Congress'

bill to overhaul Depression-era U.S. banking laws must still be formally signed by the negotiators and then goes to a final vote by the

House of Representatives

and

Senate

before being sent to

President Clinton

for signing into law.)

As

TheStreet.com

has

pointed out, the reform would allow banks, insurance companies and securities firms to merge or otherwise enter one another's businesses by repealing sections of the 1933 act that prohibited banks from engaging in securities underwriting and a 1956 law that separated insurance from banking.

The suggested reforms have sent the

Philadelphia Bank Index

, or BKX, shattering the glass ceiling, up 27.5 to 805.5.

Reliastar Financial

(RLR)

, pointed out Paul Foster with

1010wallstreet.com

in Chicago, has shot up 6 3/4, or 20%, to 41. The company's subsidiaries specialize in life insurance and related financial services. Call options on Reliastar have also ridden up the news in nearly every strike price; the November 45 calls alone gained 7/8 ($87.50) to 1 ($100) with a new position opened in the strike.

But that's the herd, Foster said.

There are other stories with less splashy headlines, and besides, "once it's out, you 'fade' the fact," he explained. (For options traders, that's the equivalent of buy on the rumor, sell on the news.)

Eternal contrarians, professional option traders generally prefer to start buying when everyone else has sold. "I'm not selling it or buying Reliastar," he added. "But were I to, I'd wait another week and see if the sector sells off. Then it's stronger buy."

For slightly more advanced option investors, there's a play on cheap implied volatility in

America Online

(AOL)

, he added.

Implied volatility -- or the percentage that the stock price is expected to swing annually -- is an important factor in pricing options. When volatility is lower in a stock, it cheapens the price of the option; when it's higher, the option rises in price, as market makers factor in the risk they take to write the option.

AOL's November 120 calls, for example, are posting volatility that is roughly at a 52-week low of around 57, Foster said. "Volatility has been pummeled," made more interesting by the fact that Internet issues were among the most volatile stocks and options in the past 18 months.

In December 1998, AOL option volatility ranked about 72 before exploding last spring to around 93 with the run-up in Internet stocks.

His final word? Avoid the herd now, before it's too late. "If I were a buyer, which I'm not yet, I'd be a buyer at these prices," he said.

Lastly, what's with the volatility of the market these days? The market's fear gauge, the

Chicago Board Options Exchange's

volatility index, has been ramping up and down as much as 10% in a day. The VIX had collapsed Friday after a rollicking week in the broader market.

The VIX was down 7/23 to 22.98.

"Short term, this is much too complacent for the market's volatility to collapse this quickly," said Greg Simmons, manager of the

Linear Capital

hedge fund. Unless the

S&P 500

index cracks the 1304 level, "we're headed south. I would short the S&Ps until volatility hits the teens again."

Infection Point

Back in July, Steris was the subject of this column for some heavy

put-buying ahead of earnings. Now, following earnings, the volatility in the options is still up in the 70s. The producer of infection-prevention products and surgical support systems could be in someone's sights. "That's what we've been hearing," said Michelle Skupp with the

Miller Tabak

options trading team in New York City. "Yes, the stock price is down, but the volatility remains high."

Steris shares were down 3/8 to 12, while the November 15 calls slipped 1/16 ($6.25) to 7/16 ($43.75).