Editor's note: This was originally published in two parts on RealMoney. It is being republished as one article as a bonus for TheStreet.com readers.
High-Volatility Investing, Part 1: Avoiding High Anxiety in Times of High VolatilityWhen the market resembles a jar of jumping beans, substituting call options can lower downside risk. It is a familiar story these days. You have pretty demanding criteria for new positions, but you do some research and find a stock that meets them. Despite your care, the stock tanks. When the market is making huge daily moves with little fresh information, investors need special tactics. In a series of articles, I am going to suggest ideas for dealing with high volatility and some stocks that fit the bill. The following strategy should be considered an alternative for any investment where you like the stock but recognize downside risk and high implied option volatility. For our purposes, assume your candidate is undervalued (in both absolute terms and relative to the market) and exhibiting a lot of volatility -- making big swings in line with the major indices. For example, Caterpillar ( CAT) has been a
- The strike price is the price at which the call holder has the right to buy the stock. For a stock substitute position, I look for deep in-the-money calls, which means the strike price is below the current stock price -- usually significantly lower. In the case of Caterpillar, the call is seven points in the money.
- The call delta is the expected change in the price of the option relative to the change in the price of the stock based on option pricing models like Black-Scholes. In a deep call -- one that is significantly in-the-money -- I can usually find a delta of 80 or so, which means if the stock price moves up by 1 basis point, the call value should increase by 80 cents.
- The option premium is the difference between the option price and the intrinsic value, also the difference between the stock price and the strike price. In our example, the Jan 30 call is priced at $8.70. If you add the strike price to the call price, you get $38.70, which is $1.70 over the stock price of $37.00. That is your option premium. If you just buy calls, you will eventually pay this premium for the advantage of reduced risk. When expected volatility is high, this price can be very steep.
- Selling a call. By selling the near-term Dec 40 call for $1.42, you recover most of the option premium.
- Position size is a crucial element. Suppose that your normal position would be 1,000 shares of CAT at $37, a total outlay of $37,000. When substituting calls, you should not spend the same dollar amount; if you did, your risk would be much greater. An equivalent position would be about 15 to 20 calls. If you bought 15 Jan 30 calls and sold 15 Dec 40s, your outlay would be about $13,000 for the call purchase less about $2000 for the call sale, for a net expenditure of $11,000. The difference of $26,000 should be held in a safe, interest-bearing account. If you invest your entire position in calls, your risk is too great.
High-Volatility Investing, Part 2: New Stock PositionsIn a whippy market, you can get a good entry price by submitting a low bid or selling puts. Investors can find ways of profiting from market volatility. Jim Cramer writes daily about apparently irrational market moves. The evidence is with him. Stocks take swings of 10% or more with little change in the fundamentals. Doug Kass has suggested that we all have a shopping list. My objective is to show ways to profit from this volatility.
The Options Approach: Selling PutsOur high-volatility series looks for an extra edge. Selling a put can provide either a short-term return or a better entry price. Here is how. A put option gives the owner the right, but not the obligation, to sell a stock at a specified price within a specified time period. If one owns the put (a condition called long the put), it is a short position. If one sells the put, it is the equivalent of a long position in the stock. While the approach can be applied to many stocks, let us use Gamestop ( GME) as our example. The company sells computer and video games and game platforms. It also purchases and sells used games. This part of the business fits well with more difficult economic times. The stores provide a way to exchange games, chat with other users and savvy personnel and get an instant trade. The company has a price-to-earnings ratio of under 11 and a forward P/E below 9. The biggest perceived threat to Gamestop is that a big-name competitor will get more aggressive about used-game exchanges. Analysts' views are mixed, but for illustrative purposes let us go with the average one-year price target of $30. That represents a one-year gain of about 25%, a reasonable target. How can we play this? Let's start with the stock chart.