Volatility can be very difficult to predict, let alone control. Random price movements make charts and technicals practically useless, and never mind fundamental analysis, which simply cannot explain violent movements that erupt after a news event. The market is designed around accumulation and distribution, which you can see very clearly on a price and volume chart. Yet, when buyers and sellers are pulled in every direction by the market, there is an uneasy feeling about participating.
The erratic behavior in price action shows up in the extreme volatility readings, when the VIX indicator is over 20 and building momentum. For the Dow Industrials, just about every day had a triple digit move in January. Stocks that deserved to go higher plummeted, and some stocks bolted higher unexpectedly. Again, this creates doubt in the minds of investors and traders.
During this time, the implied correlation index, or the $ICJ, soared higher, as one would expect. In addition, we saw increases in the skew index as the “smart money” was buying heavily out of the money puts and looking for some sort of enormous pullback.
There are a few options trading strategies to help dampen this type of volatility. Buying protection against long stocks is always a great way to hedge market risk. Professional market players always have some protection in their back pockets as insurance against a downturn. They expect this insurance to go down to a low value or even zero; the cost of insurance on a long group of stocks should exceed the losses of buying protection. You can buy insurance via shorting indices, shorting futures or just buying straight market puts or spreads.
Some will say they prefer to buy volatility, but that requires a cash outlay and knowledge about what you’re actually buying. If you want to protect your portfolio, buy a volatility index, especially if the VIX is lower and volatility pricing is cheap.
Selling premium against long stock, or covered call writing, is an excellent way to immediately lock in some gains. This is simple to do: If you own 300 shares of Boeing stock (currently at $158 a share), you would select a strike price out into the future and sell three of those call options. You keep the premium and hold the stock until expiration (or maybe before if the stock is above the strike). In the meantime, you get to sit and wait for expiration.
If you are in a winning position in a stock, implement a covered call strategy – it is one of the best and highest probability wins. I often see investors do this with stocks, and in effect they are creating their own dividend. Think about it this way: You own 500 shares of IBM stock (currently trading at $160). Looking out toward April, we see the $170 call selling at $1.63 (as of 2/20/15). We can sell five of these calls, pocket $815, and wait for two months. If the stock stays under $170 by its April expiration, then we keep the premium AND our stock.
So, we have made $815 for two months (not including any gains/losses in the stock, which is an annualized return of approximately 6% ($815 X 6, divided by total stock investment of $80K) and not including commissions). This profit is in addition to any appreciation of the stock or dividends paid out by the company. Now, of course you can be called away, but only above $170 on the stock price. Would you be disappointed with another 10 point gain on your 500 shares?
In summary, we have shown a couple of options trading strategies to protect a portfolio against some adverse moves, even violent ones. There is no exact way to eliminate all market risk (you can be close), but we can certainly dampen the volatility before a selling shower hits.
