Sell Volatility to Outsmart This Market

President-elect Barack Obama, as our nation’s 44th leader, is receiving the keys to the car with the gas tank empty, the tires blown out, the transmission broken and the battery dead.�

Hoping he can turn this wrecked car into a magical, flying one is very, very wishful thinking. We would settle for it driving 55 mph at this point, and having it stay on the road would be an even-bigger bonus!�

While the economic situation he’s inheriting makes one wonder whether anyone else will ever again want to grow up to be president, the rest of us are looking at our trading accounts and finding comfort in the fact that at least we don’t have to balance a budget on the national level!�

A Twist on ‘Buy Low, Sell High’�

As a trader, you’ve probably been advised to “buy low and sell high” so many times that your eyes automatically roll when you hear the phrase. Let’s face it, who doesn’t want to buy stocks or options “on the cheap” and close the positions for double or triple their original value?�

But what a lot of folks outside the options world don’t realize are the, well, “options” behind “selling high.” And there, friends, is where you have a unique advantage over thousands, if not millions, of investors who are neither talking the talk, nor walking the walk.�

We love to watch the “smart money” to follow those cash-flush investors into profitable trades. And with the market having some of its worst days in more than two decades, it’s only natural for us to see what the big-money players are buying.�

And lately, they’re selling.�

Now, before you access your online brokerage and tell your account rep to liquidate everything, keep in mind that “selling” isn’t just cashing out. In options-speak, it’s also called “writing” or “shorting” options.�

Exercise Your ‘Writes’ as an Options Trader�

You may already be “selling high” by “selling covered calls” against the stocks you hold long as a way to juice up your returns when share values are flatlining or pulling back. In a word, when you sell a call against your shares, you collect premium upfront and look for the option to decrease in value.�

When you sell (you’d tell your broker to “Sell to Open” your option), then you get to keep your premium and sell more calls against your stock next month, and the month after that. Or if the option still has some value left at expiration, you can “Sell to Close” your calls for a lower value at any time during the life of the contract, and still keep some (if not most) of the money you took in when you initiated the trade.�

In fact, when you’re writing calls or puts, the lower the price goes, the better for you as the options trader! Why? Because the less the option is worth come expiration Friday, the better for your trading account.�

Use Options to Bet on a Stock Bottom�

Here’s an example of how “selling high” means anything but selling out:�

With tons of busted stocks out there that are trading at seemingly unfair prices, suppose you think one in particular just has to go up. With consumers increasingly staying at home, suppose you think Netflix (NFLX) stands to benefit from families gathering around the television during the winter months. (Note that this is not an actual recommendation.)�

With NFLX trading at $20 — half of its 52-week high of $40 — you may think Santa’s going to be good to this company. So, you may decide to pick options with a January expiration date (to take advantage of the holiday season), and thus choose to sell the NFLX Jan 20 Puts for $2 per share ($200 per contract).�

Your goal as a put seller is to have the stock go up during the life of your options contract so that the $2 that’s credited to your trading account from the moment you initiate the trade stays there. If the stock keeps going up, the value of the put erodes but the money you collected is yours to keep.�

How is that possible? Because think about the position of the put buyer. We buy put options as a bet that a stock is going to go down. If the stock trades up, the option becomes worth less and less, particularly as expiration nears, as options lose their value even more quickly than usual.�

In fact, when we’re selling options, we typically try to stick with expiration dates that are close to the date we’re initiating the trade. If it’s November, we may sell a December option, or sell a January option in December, to capture premium on options that don’t have a lot of time left till expiration.�

So, Why Not Buy Calls? �

Selling puts, as you in the example above, is a way of capturing a stock’s upside. So why not just buy a call option, then, if we think a stock is going up?�

You’re probably more familiar with buying calls, and it’s a fine strategy. But when you’re buying calls, you’re laying out money from the moment you enter the trade, whereas you’re collecting money by shorting an option from the get-go.�

Your risk is limited when you buy calls, whereas the risks are much higher when selling puts. However, some of the savviest, smart-money players out there are writing puts to establish a long stock position in the names they wouldn’t mind owning at the option’s strike price. (In NFLX’s case, $20 per share.)�

‘Stock’ Up on Shorts This Season�

In these days of high volatility and, as a result, high option premiums, collecting this premium upfront (i.e., “selling high”) is much-more preferable to paying those high premiums to buy options at this time.�

So, what happens if you sell (to open) those Jan 20 Puts and the stock goes up to $25 or even $30 before January expiration?�

Then those options won’t be worth a thing, but no one can take your premium away from you. When expiration comes and goes, that money is officially yours to keep.�

But what if the stock goes down in the meantime?�

That’s why you don’t want to buy too much time, as it can work against you. But even if the stock goes in the wrong direction, you’re not stuck with a dud of a trade. You can tell your broker you want to “buy to close” your short puts at any time.�

If they’ve decreased in value, then you are still a winner, as you would be able to keep some of what you collected when you unwind the trade. When shorting options, the most you can make is what you collect on the day you initiate the position. And nothing makes a season merrier than making 100% profits on a trade that goes your way!�

Don’t Get Stuck with a Lump of Coal � Unless You Want to�

But what if the stock took a nosedive and the value of the options went up? Then you’ve got some decisions to make about how — or if — you want to make your exit. Remember, when selling puts, you should only sell an amount that you are comfortable owning if the stock is put to you.�

You don’t have to own the underlying stock to sell calls and puts, but because there is risk involved, you will need to be approved for a margin account and Level 3 trading status.�

Check with your online brokerage before doing any of these strategies, but once you see the payoff that selling volatility can make, you’ll soon see how selling volatility can bring new life to your portfolio while the market sorts itself out!