Are Options Your Only Hope?

Not so long ago, stocks like Mosaic (NYSE: MOS  ) hit new all-time highs nearly every day. Now, though, panic and fear have tightened their grip throughout the financial markets -- and protecting yourself from those losses has never cost you more.

It's been a year since the broad stock market set new records. But while the S&P 500 has dropped almost 30% from those levels, there is one measure that's been hitting all-time highs this week. It's called the volatility index, or VIX, and it's widely used to measure investors' fear about stocks.

Bad moon on the rise
The VIX takes its value from the stock index options market. With options, investors compare the strike price that the option owner pays or receives for the underlying shares to the current market price of those shares, in order to figure out how much a certain option is worth. But there's also a third important consideration: how much a stock's price moves in the short term. Options on stocks that go up and down violently cost more than options on stocks that stay relatively flat over time.

The VIX uses a complex mathematical formula to measure how much movement option traders expect to see in the S&P 500 over the next 30 days. The higher the VIX, the more expensive it is to buy index options. And right now, the VIX is at extremely high levels -- it closed at an all-time high after Monday's selloff, and after falling back temporarily, it recovered to just below those record levels yesterday.

Why should you care?
Most investors go through their entire investing lives without using or even thinking about options. Yet with share values falling through the floor, some have turned to the options market for protection from further declines. Specifically, by using a certain type of option known as a put option, you can limit your losses to whatever amount you choose.

Sounds good, doesn't it? But there's a catch.

Protection -- at a price
The problem is that with the VIX at record levels, the insurance that put options provide doesn't come cheap. For instance, look at how much you'd have to pay to protect 100 shares of these stocks against any further losses for the next two weeks:

Stock

October Put Option Cost

% of Share Price

Google (Nasdaq: GOOG  )

$27.00

6.9%

Apple (Nasdaq: AAPL  )

$7.35

7.3%

Research In Motion (Nasdaq: RIMM  )

$3.90

6.3%

Chevron (NYSE: CVX  )

$4.00

5.0%

Coca-Cola (NYSE: KO  )

$1.43

2.7%

Goldman Sachs (NYSE: GS  )

$9.30

7.1%

Source: Chicago Board Options Exchange. Options used expire Oct. 16 and have strike price nearest to each stock's Oct. 2 closing price. Option prices as of Oct. 2 and calculated using last sale price.

That's a hefty price to shell out -- and again, that protects you for just 10 trading days. In this example, after Oct. 16, if your shares were to lose value, these put options would no longer give you any protection -- you'd have to buy new ones.

The other side of the coin
A high VIX may not be good for those seeking to insure their portfolio from loss. But those who sell options benefit from greater volatility. For example, some investors use covered-call strategies, in which they agree to sell their shares if they rise beyond a certain level. They give up some potential gains in exchange for guaranteed current income -- and in a falling market, such strategies have done better than just holding shares.

Yet with shares at bargain-basement levels, trading away your upside right now might not even be worth an unusually high payout. If shares rebound, you'll end up selling near the bottom. The best case happens if the stock stays unchanged -- you don't suffer further losses on your shares, and you get to keep the money you get from the covered call.

You have choices
As useful as options can be, don't feel that you need to use them. The best protection from a falling market is thoroughly analyzing a promising stock and concluding that its business will get it through any rough times ahead. And as long as the cost of options remains so high, that confidence will save you a bunch of money as well.

For more on fear and loathing in the financial markets, read about:

  • Four reasons why you should sell stocks right now.
  • The scoop on the $700 billion rescue plan.
  • The advice on stocks that could change your life.

On Oct. 7, 2008, Fool co-founder David Gardner and his Motley Fool Pro team will invest $1 million in a portfolio designed to help you make money in any market. In the coming weeks, the team, relying heavily on proprietary CAPS “community intelligence” data, will establish long and short positions in a broad range of securities, including common stocks, publicly traded put and call options, and exchange-traded funds. To learn more about Motley Fool Pro and to receive a private invitation to join, simply enter your email address in the box above.

Fool contributor Dan Caplinger uses options from time to time, but he doesn't own shares of the companies mentioned in this article. Coca-Cola is a Motley Fool Inside Value recommendation. Google is a Motley Fool Rule Breakers pick. Apple is a Motley Fool Stock Advisor selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy tells all.


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