By Jim Melloan

Record stock market volatility is stressing out investors. Selling call and put options is a way to make it pay.

How's this for adding insult to injury: Not only do stocks seem headed for a third year of losses, but their prices are gyrating more wildly than ever. In July and October, the Chicago Board Options Exchange's Market Volatility Index, or VIX, zoomed above the 50 mark, double its level during the first half of 2002. The VIX hasn't been this high since the markets reopened after the 9/11 attacks. Before that, it hadn't hit 50 since Black Monday in 1987, the day the Dow Jones Industrial Average plummeted 508 points.

Stock volatility is a key determinant of options prices. With the VIX now fluctuating in the high 30s and 40s, options contracts are selling for about twice their price during calmer times. Options trading can be speculative or defensive and can get complicated really fast. Even so, now is a good time to take advantage of high market volatility by employing some simple options-selling strategies to generate income.

The simplest approach is to sell calls. A call option enables the buyer to purchase a stock from the seller at a predetermined strike price and future date. In return, the seller earns a premium, or income. If the stock doesn't move above the strike price when the call option expires, the seller gets to hang on to the underlying shares. If instead the underlying stock is trading above the strike price, the shares are likely to be called away by the holder of the option. In this case, the seller gets the premium but has foregone some of the stock's upside. To play it safe, investors should stick to selling options on shares they own, a strategy known as writing covered calls. (Writing naked calls, by contrast, has unlimited risk. If the stock goes above the strike price, investors could be forced to buy shares on the market and deliver them at the lower price.)

Not all stocks offer equally compelling call-writing opportunities. Investors who sell calls against shares poised to make big near-term jumps risk missing the full ride. Since traders aren't much interested in options contracts with strike prices below the typical $5 minimum, writing calls against stocks trading at less than $3 isn't worth it. Washed-out technology and biotech stocks trading in the mid- to high-single digits, however, do offer some juicy option premiums. "Beaten-down stocks are less likely to continue dropping at the rate of the overall market," says veteran options trader Tom Gentile of seminar provider Optionetics, "but most of them will experience increased volatility." Gentile likes January 2003 calls with a $5 strike price on EMC, the data-storage provider whose stock peaked above $100 but recently traded at $4.60. In late October, investors could sell the calls on EMC stock for 60 cents and earn an immediate return of 13 percent on the market value of the underlying shares.

Investors can also cash in on market volatility by selling puts. These options obligate the seller to buy a set number of shares at a strike price and future date, if the buyer decides to exercise the right. Peter Robert, head of U.S. Capital Markets for Citibank Private Bank, says that some of his most sophisticated clients sell puts on stocks they would like to own at lower prices. Take IBM. In mid-October, Big Blue's shares were selling for $72. Investors who preferred to pay $65 could have sold January puts at that strike price and earned a $3.20 premium. If the stock were to take off, the put seller would miss out on the gains. If at expiration, IBM shares sold for less than $65, however, the seller would get the stock at the preferred price. The biggest risk would be that the shares moved even lower. Still, a temporary dip shouldn't matter, since the seller was looking to own the shares anyway. As long as the stock moves higher than the strike price over time, value-conscious investors can come out ahead.

Options aren't for everybody. But as long as investors are stuck with high volatility, they might as well make it pay.


 

STICKER SHOCK: The Rise In The VIX Has Boosted Options Prices