Resolving to Remember the Value of Options - TheStreet

Resolving to Remember the Value of Options

This year's decline in implied volatility has produced leverage through cheap option prices.
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Given the outstanding performance of the major averages and incredible gains by many individual issues, many investors are once again feeling good about participating in the stock and options markets. One of the most important keys to success is to understand how it was achieved and, more importantly, not letting past success go to your head.

This is a good time to remember to some fundamental concepts of investing.

Know Thyself

A trader is someone whose primary source of income is generated through buying and selling financial instruments. An investor is someone who uses the purchase and sale of financial instruments to increase or save income.

The styles of traders can vary widely. Some of the most successful traders may only actual make a few "trades" a year. Some of the busiest bees (completing hundreds of round turns a day) end up with little to show for all of their buzzing about.

Everyone should be an investor; only a small minority of people should be traders.

Increased access to information, ease of execution and the low barrier to entry created by the Internet have many investors thinking they are traders. This was never more apparent than during the heady years of the bubble market, as many smart people abandoned their steady paychecks for the prospect of limitless profits -- only to find themselves washed belly-up on the margin-call beach.

While I don't think we'll see an armada of such rudderless proportions head out into the treacherous seas again anytime soon, the siren's song of trading for a living will always lure enough souls to sustain itself as an industry and remain one of a timelessly attractive career choice. As the saying goes, don't let a bull market lull you into believing you are a really smart and excellent trader.

I don't know the pleasure of rigging a jib or the nuances of "coming about," but lessons in sailing must be similar: start small (like on a Sunfish), know where you're going, have good equipment and tools, don't take unnecessary risks, admit when you're lost and never think you can outmaneuver a mother of a storm.

Have a Strategy, Not a System

Never trust anyone who claims to have a system or promises gains. Trading is often analogized to gambling, but unlike poker, the global casino can always introduce a new and unexpected wild card in the middle of the game. Remember those really smart guys (including a couple of Nobel Prize winners) who ran the

Long Term Capital Management hedge fund? They thought they had a system that could lock in winning positions. Then something happened that never happened before, and about $1 trillion was vaporized.

There are plenty of smart people out there in the market, making the possibility that you'll discover some overlooked method of locking in profits highly unlikely. Unless you're doing something illegal, most everyone is basically playing on the same field and bound by the same rules. Develop a winning strategy rather than trying to game the system.

The Decline and Fall of Volatility

Many active option traders have lamented this year's decline in volatility, which, as measured by the VIX, has dropped steadily from the 45% area to a seven-year low of 15%. Nearly 65% of all individual stock options have an implied volatility within 10% of their 52-week low.

Remember that the decline in implied volatility is an accurate reflection of the drop in real or actual volatility -- the

S&P 500's

60-day historical volatility is down to a mere 11%. As the lack of large price swings presents fewer big hits, the majority of people should view this as a great opportunity to add options into their trading strategy.

When options are cheap, portfolio insurance or

hedging positions through the purchase of put options becomes less expensive and increasingly attractive. Call options can be bought to replace long stock holdings to lock in profits and maintain a bullish position but reduce risk.

Straddles can be purchased that only need a small percentage price move in either direction to become profitable.

The bottom line is that what this year's decline in implied volatility has taken away in terms of price decay, it has given back by providing more leverage through cheap option prices.

Time Moves Forward

Einstein's space and time theories aside, one of the few things traders can count on is that the valuation of an option will contract at an accelerated rate over time. One strategy that takes great advantage of time decay, and has been one of the most effective this year, has been calendar spreads, also known as time spreads, which involve buying a long-dated option and simultaneously selling a shorter-dated option. Over the past year I've suggested

calendar spreads in gold, homebuilders and defense stocks. Call it theta, call it shrinkage, call it whatever you want, but understand it and use it to your advantage.

One reason calendar spreads have been so effective in 2003 is that they are an efficient way to establish a limited risk position while minimizing the cost basis. This past year of having stocks and the overall market moving in a steady direction with low volatility is a custom fit for time spreads. I think such spread strategies can continue to be successfully employed on a selective basis in 2004 by both traders and investors.

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 invites you to send your feedback to

Steve Smith.