The Siren Song of Cheap Options

It's a buyers' market, so consider using a stock-replacement strategy in your portfolio.
Author:
Publish date:

Editor's Note: This is the inaugural edition of Dan Colarusso's weekly options column. As always, please let us know what you think.

Remember the carefree days of the late 1990s, when we woke up early to watch

CNBC

and actually opened our account statements as soon as they fell through the mail slot? Back then, buying call options on tech stocks was an easy game. All it took was a willingness to pay through the nose for what would almost certainly be an appreciating asset.

Those days are gone. Tech-stock options have become cheap, but they're certainly not easy.

The Tech Garage Sale

For the past week or so, Lillian Seidman, an options trader at Miller Tabak & Co., has been carefully monitoring call options that are showing "cheap volatility." That means traders aren't worried enough about the risk to mark up the options to expensive levels; they don't foresee any quick moves in the underlying stocks. When the market was sloshing its way to nowhere, that wasn't a big surprise. But with lower interest rates and a short-term rally in full swing, sluggish options prices pose a philosophical question more commonly associated with yard sales in New Jersey: If the stuff is so cheap, is it really worth buying?

The pros were pondering that question, too. "For the past week, options premiums in techland have gotten slammed," Seidman says. "We're seeing a lot of call-option selling. It seems like nobody's in a hurry to get long." When investors sell call options, they're hoping stocks will either sit still or fall. That way, the contract expires worthless and they get to keep the premium they received.

Naturally, selling options can depress prices. But these low prices can be alluring, especially in key names like

Microsoft

(MSFT) - Get Report

,

Sun Microsystems

(SUNW) - Get Report

and

Texas Instruments

(TXN) - Get Report

. Their shares have all shown double-digit increases in the past month, with Sun's 27.5% jump leading the way. That leaves some pros wondering if the time's just about right for a "stock replacement" strategy because these options are priced to favor buyers.

How to Play It

Stock replacement is a pretty simple concept: To preserve recent gains in tech stocks, investors dump their shares and use part of the proceeds to buy inexpensive call options to stay in the game in case the rally continues. If the rally ends up faltering, as many wary market gurus suggest, the stock gains are safe and only the small amount of capital used to buy the options is at risk.

Microsoft, for instance, was trading just above $65 Thursday, and the December 65 call options were trading for $4. Investors could cash in Microsoft's 11% gain over the past month and stay exposed to,say, 1,000 shares by paying only $4,000 for the calls.

If uncertainty appears in the overall market, implied volatility will rise and likely yank both call- and put-option prices up as well. Implied volatility, an important part of an option's price, rose dramatically in the wake of Sept. 11, but has receded in the past month as the market rallied. Implied volatility measures how much the market thinks a stock can move during the lifespan of its option.

That rally hasn't impressed some pros. Bernie Schaeffer of options shop Schaeffer's InvestmentResearch says he's wary about the market's potential for further gains through the end of the year. He says he's seen a "greater sense of urgency to pay up for puts than there has been to pay up for calls" on the

Nasdaq 100 Unit Trust

(QQQ) - Get Report

.

That may point to smart money playing the market for a pullback heading into the end of the year. If so, it makes a stock-replacement plan more palatable.

Investors who have "stuck with tech stocks through thick and thin" -- and let's remember it's been mostly thin over the past year -- might find a replacement strategy "more attractive than the conceptof letting go of their hope," Schaeffer says.

Replacing stock usually means buying options with 20% of your previous gains and socking away the rest somewhere safe. With money markets paying a paltry 2%, the alternatives may seem few. Schaeffer understands the

agita

, but adds, "If they say, 'Rates are only 2%. What should I do with the rest?' I'd tell them, 'Not lose it.'"

Dan Colarusso is a New York-based financial writer. His recent work has appeared in The New York Times, Barron's, Institutional Investor and Investment Dealers' Digest. At time of publication, he held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Colarusso welcomes

your feedback.