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With the stock market having seen amazing leaps and dips over the past two years, investors have become more interested than ever in strategies that have the ability to produce profits in a variety of market environments. Many of those strategies involve options, and even though some investors are understandably nervous about using them, the right option strategy -- with the right stocks -- can bring you results that are hard to duplicate with stocks alone.
Two simple option strategies
When most people think about options, they imagine highly leveraged speculators trying to make a mint on a once-in-a-lifetime move in the markets. You may imagine buying put options right before the 1987 stock market crash, or loading up on call options right at the March 2009 bottom. Armed with perfect foresight, buying options can allow you to leverage your money to extreme levels -- and while the risks are huge, the payoffs can be enormous.
But you don't have to be a thrill-seeker to use options. For more conservative investors, there are less risky strategies that take advantage of the appetite of short-term traders for leverage. By writing or selling options rather than buying them, you get paid to do something you might well have chosen to do anyway.
For instance, the covered call strategy involves writing call options on stock you already own. Typically, you'll write options that will only be exercised if the stock rises by a certain amount. That way, you get to participate at least partially in any move up. And no matter what happens, you get to keep the premium -- the money you receive when you write the option.
Similarly, writing puts essentially commits you to buy shares of stock if their price drops below a certain level when the option expires. That can sound scary -- after all, stock prices rarely fall for no reason. But if you like a company long-term and believe you'd buy it on a significant drop no matter what the reason, then writing a put gives you some money in exchange for your willingness to buy.
Make the most of it
Both of those strategies, though, hinge on getting paid enough to justify taking on the risk involved. Right now, some options will pay you better than others. Which are the best ones to use right now?
A key element in options pricing is volatility. All other things being equal, a volatile stock will have higher-priced options than a more stable stock. That's because stocks whose prices jump all over the place have a greater chance of moving up or down enough that those options will be profitable by the time they expire-- so the options are worth more.
So with the help of some tools from the Chicago Board Options Exchange, I took a look at what current market conditions said about the state of options generally as well as which options were priced higher than others.
Here are some of the observations I made:
- Stocks with low share prices tended to have high implied volatilies. Citigroup (NYSE: C ) , for instance, clocked in at 54%, much higher than many stocks sporting more expensive shares. Sirius XM (Nasdaq: SIRI ) was even higher at 71%. That makes sense -- with Citi still dealing with huge losses and Sirius in danger of getting delisted from the Nasdaq, you'd expect those willing to take on risk to demand more compensation.
- Stocks perceived as "boring" tend to have low volatility figures. Investors don't buy stock in ExxonMobil (NYSE: XOM ) or Procter & Gamble (NYSE: PG ) expecting huge growth, because their biggest growth periods are behind them. Instead, those stocks are defensive plays that will provide steady if unspectacular returns over time -- and their option volatility supports that view, with figures in the 16% to 18% range.
- Competitors in the same industry sometimes have much different volatility figures. For instance, in the mining industry, Newmont Mining (NYSE: NEM ) has a relatively average volatility of about 33%, reflecting its modest growth prospects, steadily rising cash flow, and status as an industry leader. But as the main producers of platinum and palladium in North America -- key materials for auto production -- Montana's Stillwater Mining (NYSE: SWC ) and Canadian miner North American Palladium (NYSE: PAL ) have both benefited directly from the big move in platinum-group metals in the past year. Both have higher volatility figures to reflect that greater potential for price appreciation, in the low to mid-60% range.
Getting your hands around all these numbers is tough, but the simpler point is that higher volatility means that you'll get more premium if you write options. And more importantly, if you think those stocks won't actually be as volatile as their option prices are implying, then their options may bring you more money than they're really worth.
Take a look
As you can imagine, options can get complicated in a hurry. But used correctly, they can enhance your returns while keeping you in control of the risk level you take on.
There's money to be made in options. Find out how Fool contributor Tim Beyers found a double in three months.