Seeing Red: Stop Sign Ahead for Options Sales
thestreet.com
By Dan Colarusso
Special to TheStreet.com
01/24/2002 10:41 AM EST
There comes a time in your life when you just have to stop. Maybe you have to stop eating doughnuts for lunch, stop following redheads down crowded Manhattan sidewalks or maybe just stop worrying about how much hair you're losing. Right now, for investors, it looks like time to stop selling options.
While selling options may not be as much fun as eating doughnuts or following redheads, the risks are similar: Too much of a good thing can turn on you. For the past three months or so, selling options has been a pretty good thing. The market's moves have been gradual and slight, enabling those who sell options to collect a premium for them without much risk of having the puts or calls assigned. (That would require them to buy or sell a stock at a preset price.)
No Soft Landing
Now, however, with options prices stubbornly staying at low levels, the time has come to stop the selling. That also holds true for folks who have been selling covered calls against stock positions, ostensibly to hedge. (Alex Jacobson, an options trading mandarin who now works in marketing at the International Securities Exchange, once said that selling covered calls to hedge a stock position is like jumping out a 10th floor window with a sofa pillow to cushion the fall.)
Yep, it's time to stop selling options. There's no complicated rationale for this, no planetary overlay charts on top of the Nasdaq 100 grid. It's just simple common sense. If you're selling options today, you're not making enough money on them to justify the risk. You want to hedge? Buy a put, for God's sake. You want income? Buy a bond.
The entire idea behind selling an option is this: You want to sell it before prices start falling so that the value of the instrument you sold declines after you sell it. Now, when you sell options, you take in a premium in exchange for an obligation to buy or sell the stock at a certain price. If doing that has worked for a few months, it may be time to stop, except in certain circumstances, such as stock-specific stories that don't move with the market. Otherwise, testing your luck is likely to make you a witness to rising volatility -- and a loser on whatever you've sold.
With the Chicago Board Options Exchange Volatility Index, or VIX, down in the low 20s, the price of options on the S&P 100 index is showing that no one is in a rush to buy them. Investors instead continue to sell them because they think the market is range-bound and that current conditions make it an ideal time to take in some premium by selling puts or calls.
A CBOE trader told me Wednesday morning that guys on the floor were "choking on premium" because they were forced to buy so many options that customers were selling. Floor traders, for the most part, just get stuck buying them. What they can control is how much they'll pay, and they adjust that by changing the measure known as implied volatility, a gauge that measures their concern about future events.
A Scary Set-Up
In response to the customer selling pressure, the trader said, the folks on the floor have been slicing into the implied volatility portion of an option's price to make selling less attractive to the masses. "Customers are selling everything -- big investors, small investors, retail investors, hedge funds," the trader said. "The volatility environment is by and large a reaction to customer paper."
That could be setting up a dangerous situation, considering that the U.S. is in both a recession and a war, and most rational people could consider the event risk high. The implied volatility of the overall market should be relatively high, making options prices similarly so. Neither is happening. As a result, any significant bad news will cause a relatively greater panic "because there is no volatility," the trader said.
Dave Schultz, a Virginia-based money manager and options market veteran, says he thinks options right now "are really cheap, and there's a move coming somewhere." Schultz reminds us that implied volatility doesn't predict the direction of a move, but rather its severity. "Right now, it should be an even bet to go up or down," he says.
That may sound indecisive, but considering that the options market is signaling the market's not likely to go anywhere, it's actually a gutsy call. If he's right, that means options prices will increase. If the market rallies, the price of calls will skyrocket. If it falls, you'll be giving blood to raise the cash you'll need to buy puts. Actually, both put and call prices could rise if the market moves dramatically in either direction. "It's at the point where volatility is so low, you've just got to pick a direction," he says.
Schultz points to IBM's (IBM:NYSE - news - commentary - research - analysis) February 100 put, which has more than 20 days of life left before expiration. It was trading for just about $1 (or $100 per contract). That would mean that you'd take a mere $100 per 100 shares for the obligation of buying IBM if it falls below $100. (The stock was trading around $108 Wednesday.) "There's no juice to squeeze there," he says.
Investors would be wise not to be squeezing so hard these days. |
