What to Do Now? I’ll Tell You.

I am deeply suspicious of anyone with a strong opinion on a complicated issue. -- Scott Adams, Dilbert creator

Ever feel like you’re in a ping-pong match when listening to the experts these days? I sure do. Warren Buffett and John Paulson -- the guy who called the credit crisis -- say we’re headed for massive inflation. Experts say that’s why gold is at new highs.

But wait -- perma-bears John Mauldin and Nouriel Roubini -- who also called the credit crisis (and is now rarely photographed without a bevy of young ladies on or in his arms) -- say we’re headed for massive deflation. Experts say that’s why Treasuries are at new highs.

Eh?

This one thing can make you a lot of money
On the surface, it seems like an ordinary investor can’t make sense of the situation – let alone make money off it. But you actually can -- if you try one simple trick from the profession investors’ handbook.

My name is James Early, and you may know me from my Motley Fool Income Investor newsletter. But I’m also a former hedge fund analyst, and I’d like to share an options strategy with you that’s made for uncertain times: A straddle. You'll also find it in the Motley Fool Options playbook.

In a straddle, you don’t have to make up your mind about where a stock is going – as long as you think it’ll see increasing volatility. Here’s how it works:

You first buy one call option with a “strike” price at or close to the stock price. A call gives you the right (but not the obligation) to buy the stock at the strike price; in a straddle, you set that price to equal the stock's current price. Why would you do that? The idea is that if the stock appreciates, being able to buy it at today’s “low” price will be worth a lot.

Second, you buy a put option with the same "at the money" strike price. This empowers you to stick it to your counterparty should the stock fall, by forcing him or her to buy the stock from you at today’s “high” price. You don’t have to actually own the stock to safely buy a put, which rises in value as the stock price declines.

The trade seems to contradict itself, but because of the potent profitability of options, should the stock rise or fall a lot, you’ll make more than enough money to offset whichever side of the trade loses. In other words, all you need is volatility to win.

But you do need that; the downside is a flat stock that loses you both your option premiums. Volatility is a big deal in options land. In fact, I once attended a conference dedicated to “vol,” as it’s called by the options literati. Don’t place straddles on companies that are about to settle down from a frothy period. Instead, place them on companies about to experience higher volatility. Know any of those?

As a start, I ran a screen using Capital IQ, an institutional software platform, to search for companies with betas of 1.0 or lower. Beta is a measure of volatility relative to the S&P 500, which has a beta of 1.0 by definition. This screen is for companies that have been less choppy than the market over the past year; if you anticipate greater volatility in any of these names, you could have your first straddle candidate:

Company

Beta

ExxonMobil (NYSE: XOM  )

.705

Microsoft (NYSE: MSFT  )

.757

Wal-Mart (NYSE: WMT  )

.352

Google (Nasdaq: GOOG  )

.797

Proctor & Gamble (NYSE: PG  )

.533

Apple (Nasdaq: AAPL  )

.971

Coca-Cola (NYSE: KO  )

.407

Go with a guide
As you might guess, you can greatly enhance your straddle research by digging in to the companies above. I'd suggest picking one or two companies to follow at first to build your skill. As you do, you'll notice yourself expecting different -- and more specific -- directional movements from "your" stocks over different time periods.

That's a great thing, because where straddles leave off, the rest of the options arsenal picks up. The single best thing you can do to start using options to profit in this crazy market is to piggyback off an experienced options investor's research to start with. The Motley Fool will let you crib off our notes for free, with special access to our premium Options service’s guidebook. I know advisors Jim and Jeff personally, and recommend their material to you as a learning step. Simply enter your email address in the box below.

James Early is free and clear of any securities mentioned in this article. Apple is a Motley Fool Stock Advisor recommendation, Google is a Rule Breakers recommendation, Proctor & Gamble and Coke are Income Investor recommendations, Coke, Microsoft, and Wal-Mart are Inside Value recommendations, and Microsoft is an Options recommendation. Whew. The Motley Fool's disclosure policy gets the job done.


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  • Report this Comment On December 17, 2009, at 9:20 PM, DoWeUnderstand wrote:

    James - where were in March of this year with your concept. You missed it big time and options are not the way to go for the average investor.

    Sorry James - find a new life

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