Volatility Screen Reveals Potential Buys

Here's a tool that can help you determine what's cheap and what's not.
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The cardinal rule of trading and investing is buy low and sell high. This is especially true when using options. If you get on the wrong side of the volatility trend, you could end up losing big money.

Many equity options are trading at relatively low implied volatilities. The broadest measures of volatility, the CBOE Market Volatility Index, or VIX, and the Nasdaq Volatility Index, or VXN, have declined some 39% and 33%, respectively, over the last six weeks.

There are two main reasons for the recent drop in options' prices. First, fears surrounding the war in Iraq have dissipated, and second, the major indices have rallied and stabilized some 15% above last October's lows. As a result, much of the perceived risk has been removed from the stock market.

But one point I need to make clear: While the VIX and VXN are frequently, and often effectively, used as contrarian trading tools, the strategies discussed below aren't necessarily triggered or employed as a counter to an extreme sentiment reading.

In fact, while many people think the current readings are a sign of complacency, I would argue that we're moving back into the historically normal range. The VXN is hitting a four-year low, but bear in mind that this time frame encompasses not only the tech meltdown, which drove protective put purchases, but also the bull years when stocks were jumping 10% to 15% higher in a single day, a condition that created a speculative call-buying bubble.

Protective and Proactive

Today I want to look at the advantages of owning "cheap" options, and then identify some specific stocks sporting historically low volatilities. These are both bullish and bearish strategies that simply have a favorable profit potential profile when volatility is relatively low.

The most straightforward strategy is the outright purchase of calls or puts for a directional play. Remember that options provide leverage and offer a less expensive means of taking a position in an underlying security. That means the number of options purchased should be based on the number of shares you would be willing to buy or short, not the dollar amount.

For example, assume stock XYZ is trading $50 and you'd like to buy 1,000 shares. That would cost $50,000 or require a margin of $25,000. If you decided the XYZ $50 call, trading at $2.20, with 90 days remaining and an implied volatility of 25 offered a better value, you could purchase just 10 calls for a cost of $2,200 -- not 113 calls that $25,000 could buy and definitely not 227 calls that $50,000 would get you.

Certainly if XYZ rallied to $60 in the next three months, you'd be very happy if you owned 227 of those $55 calls, but this is a very dangerous way to trade, and in effect it undermines options' leverage. The purpose of buying options is to reduce risk, so why would you expose yourself to a $50,000 loss? Also remember that if XYZ doesn't trade above the $55 strike, 100% of your investment will be lost.

Another way to look at this is in terms of a replacement strategy. If you were long 1,000 shares of XYZ and had a $5 gain, you might want to lock in some of that $5,000 gain by selling the shares at $55 and simultaneously buying 10 XYZ $55 calls for $2 with 60 days remaining, for a total of $2,000. This assures you a profit of $3,000 while still offering you further upside potential.

Being Choosy

One way to use the leverage of owning options as a trading vehicle to capture short-term price swings is to buy straddles or strangles. With this strategy, you would simultaneously purchase puts and calls with the same expiration date, and in the case of straddles, the same strike price; a strangle involves different strikes.

The concept would be to get long a straddle/strangle with at least 90 days remaining until expiration (some would even suggest going out a year), and then fading or scaling out of the position as the price of the underlying security rises and falls.

Another strategy I've written about is

the backspread. The basic concept is to be long a greater number of options than you are short, in anticipation of a sharp move and an accompanying rise in volatility.

Buying options allows you to react in an offensive manner to any large price move. You'll be looking to lock in gains and maximize profits rather than falling back on your heels and trying to defend a losing position. The concept of trading off of long option positions was addressed in a

recent column by Cody Willard on

RealMoney

.

Offsetting trades can take many forms, including (as mentioned above), selling the underlying security, selling half of the profitable option position, selling a higher strike call or lower strike put, or selling the same strike option but with a shorter expiration to create a calendar spread.

In each case, the concept is to lock in gains while extending the profit potential using house money.

Now some examples. While providing specific strategic recommendations is beyond the scope of this column, the table below lists a few stocks whose implied volatilities are hitting three-year lows.

This only a partial list. The full screen turned up more than 100 issues. And note there are also more than 100 stocks whose implied volatilty is hitting a three-year high.

Steven Smith writes regularly for TheStreet.com. 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.