Rally Recipe: A Little Good News, a Dash of Volume

Cisco's failure to warn helped as well. And, how to play if you think the market's going to get wild.

Author:: Robert Mann
Publish date:: Apr 10, 2002 6:17 PM EDT

About the best thing that happened today was that

Cisco

didn't warn, as was widely feared. But in the absence of macroeconomic data, that -- plus positive tidings about cyclical stocks such as

Sears

(S) - Get Report

Honeywell

(HON) - Get Report

General Motors

(GM) - Get Report

and

Caterpillar

(CAT) - Get Report

-- was enough to spark a broad-based rally.

The

Dow Jones Industrial Average

rose 1.7%, the

S&P 500

gained 1.4%, and the

Nasdaq Composite

climbed 1.3%.

Technical factors may have been behind the advance; major averages had trended toward the low end of respective trading ranges yesterday. Still, the session was noteworthy for an increase in trading activity. In

New York Stock Exchange

action, 1.44 billion shares were exchanged, a 10% increase from its six-month average, according to

Bloomberg

. Nearly 1.8 billion shares traded in over-the-counter activity, its busiest session since March 8.

Gaming Volatility

The following is an update from an earlier column today.

Today's advance wasn't entirely smooth, as solid early gains faded in late morning trading before recovering in the afternoon. Although the Dow traded well in positive territory throughout the session, the Comp traded briefly in negative territory -- as low as 1733.69 -- after having traded as high as 1772 early on. The index closed at 1767.07.

But as has been the case throughout the week -- which is shaping up to be a pretty wild one -- there wasn't a whole lot of volatility, at least not according to the Chicago Board Options Exchange Volatility Index. The VIX, which measures the implied volatility of a theoretical 30-day, at-the-money S&P 100 Index option, fell 3.9% to 20.22 today.

Despite the market's swings -- Monday's intraday reversal was followed by Tuesday's slump which gave way to today's advance -- the VIX has remained relatively subdued this week, having traded as high as 22.81 and as low as 19.01 on an intraday basis.

Even the CBOE's Nasdaq Market Volatility Index, or VXN, fell 0.9% to 42.07 today despite the Comp's intraday fluctuations.

Still, John Bollinger, president of BollingerBands.com in Manhattan Beach, Calif., noted the VXN has picked up of late, having risen 17% since March 28 before today's modest setback.

Thus far, the VXN is in the "just a keep-an-eye-out" stage, but its recent upturn is an alert there may be more pressure on the

Nasdaq 100

, on which the VXN measures implied volatility, Bollinger said. "I wouldn't be surprised to see the over-the-counter

market continue to deteriorate and the VXN rise as people get worried about last fall's lows failing to hold."

Then again, he "remains focused in the small-cap area" which made another 52-week high today, as measured by the S&P SmallCap 600.

Playing Volatility Ball

reported previously , the VIX is actually trading in high range, relative to its long-term trend. Options market veterans believe the index is reverting to its mean, suggesting it will ultimately settle into a range in the mid-to-high teens.

But many market participants cannot get over visions of the late 1990s and early oughts, when the VIX traded in a range between the high 20s to high 30s and routinely, it seemed, pierced 40 and above.

Those participants remain convinced a spike in the VIX is forthcoming, even if opinions vary greatly over whether the coming volatility will be of the up or down variety. Although volatility became a euphemism for a down market in the late 1990s, it really applies to sharp moves in either direction.

Nostalgic Detour

So this album's for you people, man.

(In the tradition of John Roque, a free copy of the 2002

Stock Trader's Almanac

for the first emailer to correctly identify that reference; the artist and the LP, that is.)

Back to Regular Programming

For those expecting volatility but aren't sure whether it's going to be a big spike up or a big whoosh down, the question is: What's the best way to position your portfolio?

"If you think we're going to have some kind of violence in the market, the best way

to profit is with straddles or strangles in the options market," according to David Lerman, a former options trader and current associate director of equity index products at the Chicago Mercantile Exchange.

Say, for example, you want to bet on increased volatility in the S&P 500, which closed just above 1130 today: To do a straddle, you would buy an 1130 call and an 1130 put; the key being having puts and calls with the same strike price.

To do a strangle, you'd buy out-of-the-money options, say an 1180 call and a 1080 put. Ideally, the out-of-the-money options would be the same distance away from the current price, so you'll get a relatively equal profit, regardless of direction. If prices fall, then the put will gain value at a higher rate than the call, and vice versa. In a decline, the put will be closer to its strike price and presumably enjoy increased demand while the call, which is already out of the money, will just be more so.

Because the options are out of the money, the cost is a little cheaper to do a strangle but you need a bigger move to make a profit, Lerman said. In both the straddle and strangle, one side of the trade -- the call if the market tumbles and the put if it rallies -- will expire worthless, but the profit on the other side of the trade should more than offset the price of the option.

The same strategy can be employed for individual stocks and commodities, as well as market averages. For example, if you had a straddle with a 100 call and a 100 put on

IBM

(IBM) - Get Report

heading into this week, "the put would have exploded in value," after Big Blue's profit warning Monday, he said.

Brokerage firms offer institutional clients products known as "volatility derivatives," which essentially mimic a straddle or strangle trade. For individual investors, the choice is whether to buy the put and call at the same time or individually, which is know as "legging the spread," Lerman explained. Either way, such strategies entail buying two premiums -- meaning two commissions -- and investors should be careful because bid/ask spreads can be wide on some products.

"It's unlikely you will be able to hit both bids on a straddle," he said. "You have to finesse the trade."

Speaking of finesse, many thanks to

RealMoney.com

contributor Dan Fitzpatrick for his insight on these strategies and contributions to this piece.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.