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Sky Isn't Falling in the Options Pit

The Nasdaq retreats, but call-option prices hold steady.
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Is it a downturn or not? Some options investors apparently don't think today's 2.5% drop in the


means the end is nigh.

Many call-option prices were lagging the decline in underlying shares, especially in the tech sector. Several options specialists say that reflects the belief there's some more volatility, not just a pullback, in store. "The prices aren't coming down as quickly and that could mean that market makers may not think this downturn is a permanent thing," says John Hayes, options strategist for

Tucker Anthony


That, or the market makers are reluctant to cut the premiums on call options, since they've gotten trampled regularly over the past few months when they stood in the way of galloping tech and Net stocks. Keeping the premiums high at this point might keep the flood of buyers at bay and protect the market makers if tech stocks start to run again. Hayes says he can't blame the market makers for being cautious considering how they've fared recently. "They've been slaughtered," he says.

As a result of the premiums remaining relatively high, options activity was muted. Stewart Winner, director of retail options for

Prudential Securities

, suggests options investors may be watching the Nasdaq to measure the severity of its pullback. "I think that people don't believe this will be a real, long-lasting downturn," Winner says.

One way to play the disparity between falling stocks and expensive call options is to do what's called a buy/write, in which an investor buys the stock as it falls and writes (sells) a call against it, Tucker Anthony's Hayes suggests.

Using that strategy, the investor buys the stock but offsets the cost of the purchase by selling a call for a relatively hefty price. If the stock rises and the investor gets called on the option, he still has the premium. With the disparity between the price of stocks and calls today, this could be a profitable strategy, Hayes says.

For example, the stock of software company

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was trading at 97 3/4, down 2 1/4, this afternoon. February 100 calls, however, were still trading for around 7 1/2. That means an investor could buy the stock at 97 3/4, then take in 7 1/2 for selling the call. If the stock goes above 100 and the option gets called, he gives up the stock and gets 100. That means he takes in a total of 107 1/2 for an outlay of 97 1/2.

As long as the stock doesn't run too high by February's expiration (Feb. 19) and he then has to give up a stock now worth, say, 110 and climbing, the trade looks like a profitable wager.

Still, not everybody was seeing today's downturn as temporary. One investor took about $500 million worth of downside protection in the

Nasdaq 100

index, or NDX, in an apparent show of white-knuckle caution. The index, which trades on the

Chicago Board Options Exchange

, dipped 57.4, or 2.8%, to 1976.3 this afternoon.

The investor rolled 2,516 contracts in the NDX's in-the-money February 1800 puts, selling them to buy 2,639 contracts of February 1960 puts, according to Leon Gross, options strategist at

Salomon Smith Barney

. Because the February 1800s brought in premium worth 27, or $2,700 per contract, and the February 1960s cost about 71, or $7,100 per contract, the investor also sold 2,500 contracts of February 1680 puts at 14, or $1,400 per contract, to help defray the cost of the trade, Gross explains.

"Moving this large a position closer to the money indicates extreme nervousness," Gross says.