How You Can Profit From High Volatility

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 Volatility

When 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 popular pick on the site and I like it a lot. The normalized earnings growth rate is good, the company is practicing cost containment and plenty of orders are already booked.

However, the trading range is difficult to determine. For Caterpillar believers, the recent price is already outside the range. When a sound bottom cannot be identified, it is more important than ever to address downside risk. In a market where some cyclical stocks trade at one or two times earnings, there is plenty of risk. Substituting call options for a stock can be a good method to limit downside risk.

To make the example easier to follow, I will start with the answer and review the process. The recommended position is the purchase of the Jan 30 call at a price of $8.70 and the sale of a Dec 40 call for $1.42. The prices given are all real at the time of writing, with the stock trading at $37.00. (By the time you read this, the exact prices will have changed, but the illustration is still valid.)

I usually look for a deep call two to four months out. When buying this type of call, there are several things to look for.

  • 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.

The key advantage of this position is downside protection: If the stock pulls back rapidly, the deltas in your long call will decline, cushioning your loss. The implied volatility will expand, also increasing the call value. Even if the stock declined to $33, your long calls would still be worth more than $5 given the increase in volatility. Briefly put, your absolute risk of loss is dramatically reduced; your practical risk is even lower.

The trade has plenty of upside gain. If the stock rallies to $40 or above before the December expiration, you make $3.00 minus the difference in call premiums, 28 cents. This is a gain of $2.72 times 15 calls, or a total of nearly $4,100 in a few weeks, a nice return on your $11,000. If the stock treads water, or rises slowly, you pocket the premium from the call you sold and have the opportunity to sell a January call or reset the entire trade.

Volatility pops when the stock declines and shrinks when it moves higher. During part of Wednesday's Nov. 26 trading, I was actually showing a gain on both my long and short calls as the Caterpillar rose. The implied volatility in the short call was coming out so fast that the option was losing value even with the stock price increasing. Let that be a warning to those who buy near-term out-of-the money options when volatility is high.

Consider limiting risk by buying a deep call as a stock substitute. You can also sell a front month out-of-the-money call with a fat premium that will disappear rapidly. The combination gives you a very reasonable upside play with excellent downside protection, and compares favorably to buying calls and paying a big premium.


Know What You Own: Caterpillar operates in the farm and construction machinery industry; other stocks in this field include Hitachi ( HIT), Deere & Co. ( DE), CNH Global ( CNH), Joy Global ( JOYG), ACGO Corp. ( AG) and Bucyrus International ( BUCY).

High-Volatility Investing, Part 2: New Stock Positions

In 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.

A plan starts with finding attractive stocks. Whenever one of my astute RealMoney.com colleagues suggests buying on a pullback or a dip, there is an opportunity.

One approach is to make what Art Cashin calls "silly bids." You pick a price where you are willing to enter a new position and place a good-till-canceled bid. If we get a situation where there is massive selling where bids are pulled, you have a chance of getting filled at your price.

This is a good method. There is no compulsion to enter new positions, so it is wise to be picky about the price for a new buy. The entry price has a great effect on the final return.

The Options Approach: Selling Puts

Our 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.

Gamestop (GME)

chart
TheStreet.com

A potential buyer might look at the apparent retest at about $20 and look to buy at that price.

The Jan 22.50 put is trading for about $1.80. If we were to sell this put, and if the stock is above $22.50 on Jan. 16, the expiration date for these options, we would pocket the premium of $1.80. Not bad! If the stock closed below $22.50, we would be assigned on the put. This means that we would have to buy the stock at $22.50. Since we collected the $1.80 premium, our effective purchase price would be $20.70, close to the expected support price.

It is an attractive way to enter the position while being a bit fussy about the price. One might also consider selling the Jan 20 put for a dollar, an effective entry price of $19. Some would find this purchase less attractive if the stock broke $20.

A Bad Rap for Put Sales

Put-selling has something of a bad reputation. This dates from the mid-1980s, when investors who did not understand options were encouraged to sell puts as a source of "free money." That should have been a warning, but it worked well for a long time, developing many adherents. Naive investors had massive losses in the crash of 1987, since the puts exploded in value. Many had large margin calls and forced liquidations.

The strategy was so popular that many advertised in Barron's about this wonderful trading system. Some of these ads were scheduled and ran the week after the crash!

The key to selling puts is a willingness to buy the underlying stock. People made a typical mistake. They asked how much money they wanted to make, and sold that number of puts. An investor should start with risk, not reward. In the Gamestop example, if a normal position size would be $20,000, or a buy of 1,000 shares, you can sell 10 puts -- no more.

When Not to Sell Puts

The risk in selling a put is limited in the same way that buying the stock is limited. If the company goes bankrupt, your loss is equivalent to that of owning the stock.

The reward is also limited. If you are not assigned on the put, you merely collect the premium. You could try the same strategy in a future month, but the stock may have moved higher. If you expect explosive returns from a stock, selling puts is not the most effective entry.

There are many stocks where an investor looking for an entry point may wish to consider the put sale. Given the 1987 experience, many brokers limit the use of this strategy, so you may have to demonstrate that you understand what you are doing -- especially regarding position size.


Know What You Own: Gamestop's competitors include Amazon ( AMZN), Best Buy ( BBY), Barnes & Noble ( BKS), eBay ( EBAY), Circuit City ( CC) and Wal-Mart ( WMT).

This was originally published on RealMoney on Dec. 1 and 15, 2008. For more information about subscribing to RealMoney, please click here.

At the time of publication, Miller was long CAT and GME (in personal and managed accounts), although positions may change at any time. Jeffrey Miller is president and CEO of NewArc Investments, a registered investment adviser, and Capital Markets Research.

Miller writes about the market, interpreting data, and finding the right expert at his blog, "A Dash of Insight. He is writing about the 2008 presidential campaign and the implications for individual stocks and the market at Election Stocks. His investment company, with programs for both individual and institutional investors, is NewArc Investments.

Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Miller appreciates your feedback; click here to send him an email.