Strategies for Trading in a Range-Bound Market

The VIX explained, protecting a big AOL position and more.
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Before the explosion in the Dow on Thursday and Friday, the range-bound market had made options more difficult to trade. As a result, this week's questions deal with a pricing issue, an explanation of the VIX and some quick advice for a prospective put buyer.

Enjoy, and keep your questions coming to

Price Divergence

When pricing both puts and calls on an underlying security, are there any differences, or does the premium on both sides remain generally constant? Over the last month, I have been put hunting, and with the put/call ratio so low, I was expecting to find some softer put premiums. In almost every situation, however, the premium on equidistant strikes was about the same. For example, in early January, with Cisco (CSCO) - Get Report at 102 1/2, the February 100 Puts were trading at $6 and the February 100 Calls were trading at $6.25. With such minimal interest in the put side of most issues, why doesn't the market drive a bigger disparity? Or are they priced with the same issue model (using vols., etc.)? -- Mark M.


That's an interesting question, and while option prices often look like they are related to supply and demand, they really aren't.

A major part of the option's pricing model is implied volatility -- the measure of how much a stock is


to move -- and that component is the same on both sides of the ledger. The volume doesn't matter, although equity calls do generally skew slightly more expensive than the corresponding puts.

The reason for that lies less in supply and demand than in another component of the options pricing model: interest rates. When you buy a call, it is seen as a stock surrogate, and you are charged as a surrogate for a long position.

Prices need to be kept in line because if they fall out of whack, it would provide hedging difficulties for market makers and arbitrage opportunities that could affect the overall liquidity of the market.

We'll try to explain this as simply as possible. It's due to the vagaries of leveraged finance. There is a concept called "put-call parity."

That's a basic formula that expresses the economic connection between an underlying market and its derivatives. Essentially, the formula says that you can replicate a stock position (in terms of risk/reward parameters) by combining options with a T-bill thus:

Stock = Call - Put + T-bill

Without going into the mathematical niceties, the formula dictates that there


a difference in how puts are priced vs. calls.

So, buying a call is equivalent to: Call = Stock + Put - T-bill (borrowing at the risk-free rate).

While buying a put is simulated by: Put = - Stock + Call + T-bill (lending at the risk-free rate).

Keep in mind that in any option pricing model, these five factors are used to derive an option's premium:

  • Current stock price
  • Option strike price
  • Time 'til expiration
  • Cost of money (risk-free interest rates vs. dividends)
  • Volatility estimate for stock

Most important in understanding your quandary is knowing the relationship between the risk-free rate and the dividend yield on the underlying security. Where rates exceed the yield, options exhibit positive leverage. Where the reverse is true, options have negative leverage.

In the case of Cisco, dividend yields are nonexistent. In such a market, put premiums may seem inflated when compared with calls because call holders effectively forego positive returns associated with holding the underlying security while put holders, by implication, receive those returns. The market value of the options (premiums) are priced to reflect that condition.

Deconstructing VIX

I've been studying hard and reading

Options As A Strategic Investment

and I'm signed up at a couple of sites that deal with options. I get reports emailed to me every day from CBOE with the statistics. One of the numbers the exchange includes are the readings for the VIX. Here's an example: VIX Opening Value: 27.28
VIX High Value: 29.29
VIX Low Value: 25.78
VIX Closing Value: 28.81 I just don't know how to read these figures. Can you help me out? -- Jacki Fromme


For the past few weeks -- at least before the Thursday and Friday explosion in the Dow -- the market had been range-bound, leaving traders to seek out old-fashioned indicators to determine what might happen. One of the favorites is the Chicago Board Options Exchange

Volatility Index


The VIX is commonly used as a "fear indicator" and is computed by measuring premiums on eight near-the-money strike prices on

S&P 100

index options. During the summer of 1997, the VIX was at an alarmingly low 16. These days it is bouncing around the high 20s and low 30s.

Based on recent levels, a VIX higher than 30 would indicate there was concern about the overall tenor of the market. Literally, it would mean that put prices (actually put


call prices) would be higher.

A VIX lower than 30 would mean investors weren't willing to pay high prices for the protection of a put on the S&P 100 index.

Now, understanding all that, you have to remember that these are used by contrarians, and that turns the whole equation on its head.

A high VIX means more caution, which professionals believe means too many investors are now betting on a downturn. Since contrarians believe the masses are always wrong (or at least late), a high VIX could portend a market rally.

A low VIX, on the other hand, means that complacency, as reflected by wholesale call buying, has set in on the market, that the masses who are buying are late and that a downturn could be imminent.

Remember, though, the VIX is an extremely short-term indicator and you can't plan your life by it. It is, however, a quality gauge of how expensive options are compared with other points in the past, and that can help you determine if an option strategy is manageable.

AOL Puts

I have a sizable amount of America Online (AOL) stock, and though I'm bullish long term, the volatility can be stressful. I was wondering whether put options might be an effective way to limit my downside. -- Steve Brando


A put buy is always a nice way to protect a position, but you have to keep a close eye on the premium, and on whether the price you pay for the option is as much as you could lose in the stock.

You don't want to pay $500,000 to insure a $400,000 house. For instance, if you buy an April 85 put, it'll cost you 6 1/8 ($612.50) for each contract.

Let's say you buy 10 to cover a 1,000-share position in AOL stock. That'll run you over 6,000 clams. If you don't think you're in a position to lose that much money on your long AOL position, then don't bother buying the options.