When Stock Market Volatility Is Your Best Friend
Stock-Markets / Stock Markets 2015 Sep 08, 2015 - 05:19 PM GMTBy: Investment_U
Marc Lichtenfeld writes: Most people who talked to me about the market last week were shaking their heads, trying to make sense of the extreme up-and-down moves. But a few smart investors simply shrugged their shoulders and said, “I don’t care. I’m selling the volatility, so it’s been great for me.”
What they mean is that they are selling options - calls and puts. And they’re not selling them to close positions. They’re starting new ones, but selling first and buying them back when they’re cheaper.
It’s the reverse of buy low, sell high. They’re selling high then buying low.
Volatility is an important part of an option’s price. When volatility increases, so does the price of options.
Be Your Own Insurance Company
Most people don’t care for their insurance companies - who charge a lot for coverage and don’t always deliver what they promise. Wouldn’t it be nice to be an insurer? These companies usually make boatloads of money.
When you sell calls and puts, you are essentially acting like an insurance company. You get to keep the premium and put it in your pocket. And if the event you’re insuring against occurs, you pay the insured.
Here’s how it works. Let’s say an investor wants to buy insurance on his shares of Wells Fargo (NYSE: WFC). He wants to make sure that if the stock goes down, he doesn’t get hurt too badly.
As I write this, Wells Fargo is trading at $53.40. The investor wants to make sure he can sell his stock for at least $50, so he buys a put option with a strike price of $50. If he wants to insure his stock until January, he’d buy the January $50 put. That will cost him $1.80 per share or $180 per 100 shares (option contracts usually consist of 100 share lots).
The seller of the put will collect that $180. And just like an insurance company, if the insured event (the stock falling to $50) never occurs, the seller keeps the money. If the buyer of the put “makes a claim,” the seller must buy the stock from her at $50.
It’s important to note that, similar to buying insurance, the insured event may occur, but the insured doesn’t always incur damage, so she doesn’t collect from the insurance company.
For example, I have insurance for my home against hurricanes. The last time one hit South Florida, the eye passed right over my house. We were fortunate that we lost only a few roof tiles, so I never made a claim with the insurance company.
If Wells Fargo shares fell to $49 next week, the buyer of the put is unlikely to make her claim, as there is plenty of time between next week and January for the stock to rebound.
However, if the stock is at $49 when the option expires in January, the buyer will make a claim and the seller will have to buy the stock at $50.
And just as an insurance company can suffer significant losses when there is a natural disaster, so can a seller of puts.
If Wells Fargo is at $30 in January, the seller is obligated to buy the stock at $50.
However, there are steps the seller can take in advance so that they are not buying the stock at a much higher price than it’s worth. They can buy the put back (most likely at a loss), which would mean they no longer have an open position and are now free of that obligation.
This is a good time to remind you that you should only sell puts if you’re willing to own the stock that you’re selling insurance against at the strike price. So if you hated Wells Fargo, it would not be a good candidate for you to sell puts on. But, if you like the idea of owning Wells Fargo at $50, you’re getting paid $180 to wait and see if the stock comes down to your price. If not, you just keep the insurance premium and write another policy if you choose.
Exploring the Other Side
Selling calls is similar. A short seller might buy a call to protect themselves from the stock going higher. Or an investor might buy a call as insurance against the stock going up without them being able to participate.
Pfizer (NYSE: PFE) is trading at $32.37. If an investor were interested in owning Pfizer at $34 or below, but didn’t want to put up the full $3,400 per 100 shares to participate in the upside - or she wants to risk just a little bit of money that the stock is going up - she can buy the January $34 call for $1 per share or $100 per 100 shares.
The seller of the call collects the $100. If in January, the stock is above $34, the seller of the call must sell shares of Pfizer to the buyer for $34. If the stock is at $50, the call seller must still sell the stock at $34. However, if the stock is below $34, the seller simply keeps the $100.
Finally, a covered call is when you already own the stock and sell a call against it. It’s a great income strategy because you often collect the option premium and don’t have to sell your stock. But you must be ready, willing and able to sell the stock at any time when you’re in a covered call position.
Using storms in the market to sell put and call options is a great way to earn extra income. For more information on how puts and calls work, you can check out The Oxford Club’s Essential Options Manual.
If you have some experience with options and want help selling puts and calls, you can get more information on my option selling trading service Dividend Multiplier here.
The next time markets get volatile, don’t just stand there taking a licking. Use the volatility to your advantage to put money in your pocket.
Good investing,
Marc
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