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In the wake of Wall Street's unprecedented turbulence over the past couple of weeks, many investors have made their typical knee-jerk reaction to risk: They've gotten scared. But great investors know that the best opportunities often arise when everyone else is too afraid to take advantage of them -- and if you're willing to expand your investing horizons, you'll find that some strategies are more attractive right now than they've been in months.
Volatility is back
The thing that's hardest to remember after a prolonged rally like the one we've seen since early last year is that they always come to an end. Markets can only move straight up or down for so long. More often, they're swaying back and forth -- sometimes gently, sometimes violently. Strong rallies lull investors into a false sense of security, especially after a painful bear market that most people would just as soon forget.
When markets fall and bounce back and fall some more, as they've done most severely during May, it can sap your will to take action with your money. Buying on dips may seem smart -- until your stock gets cheaper still, suddenly leaving you with a quick loss. When the rules change, what's the best way to profit?
What many people don't realize is that the level of market volatility itself is a measure that investors can buy and sell. The much-watched VIX, also dubbed the "fear index," measures volatility -- but the way it does so is to look at and compare the prices of various index options. When fear rises, so does the VIX -- because investors are paying more for options to protect their portfolios. As fear subsides and the VIX falls, so, too, do options prices.
So if you think the recent market turbulence is just a short-term phenomenon, then betting on falling volatility may seem like a smart move. How do you do it?
There are a few exchange-traded products that offer direct exposure to VIX futures contracts. The iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX ) is an exchange-traded note that tracks VIX futures over the closest two months, while its iPath S&P 500 VIX Mid-Term Futures ETN (VXZ) looks at futures four to seven months out. But a host of problems, such as the upward-sloping nature of VIX futures as you go further into the future, has helped cause the short-term product to do much worse than its longer-term cousin. That puts ETN issuer Barclays (NYSE: BCS ) in a vulnerable situation in the VIX-product market and has motivated competitor Jefferies Group to file for a true VIX ETF of its own.
Write 'em up
Betting directly on the VIX, though, is complicated. An alternative is to write options of your own. A high VIX suggests that the premiums you receive for writing options will be higher than they were before the market started getting choppy.
Which type of options you write depends on both your current portfolio and your view of the market. If you're looking to increase your exposure to stocks, writing put options can set you up to buy stocks at attractive net prices if markets fall -- and it gives you guaranteed income if they don't. In contrast, covered calls may result in your having to sell existing holdings -- but again, the money you receive for writing the option is yours to keep no matter what happens.
Before you write options, though, make sure you understand the following:
- Some stocks offer bigger option premiums than others. Green Mountain Coffee Roasters (Nasdaq: GMCR ) , for example, has lost a quarter of its value in just the past month as doubts arise over whether it can sustain its growth. As a result, you can get a premium worth more than 5% of the share price if you're willing to commit to buying shares for $75 in the next month. A similar option on Wal-Mart (NYSE: WMT ) , however, would get you only around 3%, as the big retailer doesn't face the same concerns and could actually benefit from a return to recession.
- Anticipated news items such as company earnings can create huge volatility. For instance, when Baidu (Nasdaq: BIDU ) recently announced strong profits, the stock jumped by 14% in a single day -- making those who'd written covered calls wish they'd simply held on to their stock.
- Sometimes, what causes a stock to lose value may change your mind about wanting to own the stock -- yet after you write an option, you can't change your mind. For instance, the stock drop after TiVo's (Nasdaq: TIVO ) setback in its lawsuit against DISH Network (Nasdaq: DISH ) means that put-writers could get stuck with shares they no longer want.
Writing options isn't a free lunch. But if you understand the pros and cons, you can use them to your advantage -- and with heightened tension in the financial markets, the rewards for selling options are greater than ever.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.
If you want to learn more about options, check out The Motley Fool's options tutorial.