When Markets Get Tough, The Tough Sell Options

Includes: AUY, CSCO, PAAS
by: Davy Bui

Readers should know I fancy myself a value investor, not an options trader. But conservative investors can benefit using options even if they don't know much about the Greeks or implied volatility. Two strategies in particular -- covered call writing and naked put writing -- can be extremely valuable to long-term investors in volatile times for a couple of reasons: They help generate positive returns in the face of declining markets and they take advantage of the one index that is going up (the VIX).

One thing to understand about options is they price volatility. Thus, recent days' volatility serves to increase the price of options as investors seek to hedge stock exposure. Savvy investors can cash in on investor fear by selling expensive options, such as covered calls on stock they already own and are dropping in price or naked puts on stocks they wish to own.

For example, early last week I sought to sell covered call options for Yamana Gold (NYSE:AUY) at a strike price of $15 due in October 2011 at a sell bid of $0.48, a premium of 4% on the underlying stock's price on that day. Fortunately for my portfolio, I was unable to hit my bid and sell that contract. Then the markets crashed on Friday and I sold $16 calls at $0.40, extracting nearly the same premium on a stock selling near levels earlier in the week but adding 7% on the strike price, meaning I will realize more gains even if I am exercised out of my position come October. Should that occur, I will realize an 8% gain on the stock in addition to pocketing the option premium. Of course, there is every chance that AUY fails to top $16 when the option contract expires, in which case I pocket the premium and retain my position.

I have expressed my bullish view toward Cisco Systems (NASDAQ:CSCO) in the past, and with the stock hitting new lows, I used naked puts to generate cash while also creating the possibility of buying the stock at even lower prices in the future. During mid-day Tuesday trading, with the stock selling around $13.80, I sold CSCO put options at a strike of $13 expiring in November at a price of $0.86 per contract, a 6% premium. With the stock's current trading patterns, there is a good chance the stock will drop below $13 and I will be forced to buy the shares. If so, my true cost of those shares would be $12.14 ($13 strike - $0.86 premium), 14% lower than Tuesday's closing price. If the market or CSCO shares rally, I still pocket the 6% premium. I considered writing similar puts on Berkshire Hathaway (NYSE:BRK.B) and Talisman Energy (NYSE:TLM).

Like any investment, these options strategies do carry risk but mainly opportunity risk. In the case of covered call writing, investors risk losing out on bigger gains if the underlying stock moves higher; in fact, I am in that same position with Minefinders (MFN): The stock has moved well beyond my $13 covered calls and I will be exercised out of my position next week at $13 with the stock trading around $15. With naked puts, investors take the risk of having to buy stock that is headed lower. Studious value investors should welcome this risk as an opportunity to build a position at prices below what is quoted today, but the possibility always exists that we are wrong on our investment call and the stock could go to zero. But that risk would exist whether we sold naked puts or bought the shares outright, as I already have with CSCO. In this way, selling naked puts actually mitigates that risk as it lowers my cost and reduces total possible loss by the amount of the premium collected upfront. Beyond that, most brokerages require investors to set some capital aside to cover the naked position. I prefer to be 100% covered on naked puts to prevent being margined out at any point.

Markets closed Tuesday trading on a spectacular rally but the whipsaw volatility suggests exciting days still lie ahead for investors. While stock prices have dropped substantially since last week, grade-A bargains are still difficult to find so instead of taking positions at decent prices, I will look to use naked puts to set better entry prices or collect premiums in a risky environment. Investors should always look to buy low and sell high and right now, volatility is at a premium.

Disclosure: I am long AUY, CSCO.

Additional disclosure: I am short AUY call and CSCO put options.