Recently, high volatility is causing some option strategies, such as selling strangles, to look appealing again (see WSJ article). A strangle is an option strategy where you buy out-of-the-money puts and calls, as opposed to a straddle where both options are at-the-money. For those buying the position, you are hoping for volatility - with movement in either direction. Right now, as a result of higher volatility, the strategy is more expensive than it has been in the past, offering opportunity for those who sell the position. Typically, selling the strategy is safer when the straddle options are deeper out-of-the-money, but of course, deep out-of-the-money options do not usually generate as much premium - until now. The higher volatility has increased premiums to the point that deep out-of-the-money options, even for those tied to historically lower volatility stocks, are looking attractive. Each position needs to be considered carefully for risk and reward, but those with the stomach to sell option are seeing new opportunities and possibilities.

There is an interesting Bloomberg article today giving a postmortem on the Bear Stearns stock decline. In particular, the purchase of deep out-of-the-money puts are investigated. As quoted in the article, "On CSI Wall Street, the options are the DNA." As it turn out, trade data shows that 5.7 million puts traded on March 11 of this year at the $30 strike price, along with 1,649 that traded at $25, worth in total about $1.7 million. The kicker, and why this is raising eyebrows, is that when purchased these puts were over 50% below the March 11 closing price of $62.97, and also only had about a week and a half until expiration. As far as the investigators are concerned, the traders either were buying a lottery ticket, knew something was going to happen, or were in the process of making something happen. Rumors of insolvency and investor concern filled the airwaves for the rest of the week putting further pressure on the stock until it was trading around $30 by the end of trading on Friday the 14th. On that same day, with the stock opening around $54.24, the CBOE starting listing eight new put option contracts with strikes going down from $22.50 to $5, each with an expiration of only one week. That same evening Treasury Secretary Paulson called CEO Schwartz stressing the need to find a buyer to avoid the appearance of a Government bailout. And as they say, the rest is history. Even more suspect is that on Friday March 14, a total of 6,303 of the $5 strike puts traded, above the $2 initial purchase price, but well below the Friday closing price. I am sure those individuals have been receiving some calls, as well as making a few call themselves.

Nice article at the Crossing Wall Street blog about shorting puts to acquiring stocks at cheaper cost. The basic idea is that if you want to buy a stock, why not just sell puts against it, receive the put income, and then wait. If the stock goes up, you at least get the put premium as income. If the stock goes down, you capture the stock at a lower price. Of course, the immediate risks are that 1.) the stock goes up and you do not get to participate in the upward gains, other than the put premium income, and 2.) the stock goes down a great deal below your written strike price, forcing you to buy a cheaper stock for a higher price. For 1, you do give up potential gains, but are not adding negative downside risk. For 2, this certainly does involve downside risk, but if you bought the stock, you would also incur a loss, possibly more, since you probably bought at a higher price and also did not gain any option premium income to offset your purchase price. Buying the stock and placing stops would involve less risk, but given a gap down at the open, you would also not see the benefits of the stops, and would have similar risk as the put position. If the move down is slow, then monitoring of the option can reduce some of the same risk, but not all. Of course, the strategy works when long-term options are written in order to generate more income, and is obviously more profitable when the implied volatility of the option is high.

Furthermore, as mention at Crossing Wall Street:

"What makes this technique so effective is that it exploits the fact that option prices do not reflect the expected long-term growth rates of the underlying equities. The reason for this is that standard option pricing formulas, used by option traders everywhere, do not incorporate this variable. With short-term options, this doesn't matter. With long-term options, however, this oversight often leads the market to overvalue premiums. Taking advantage of this mispricing is the foundation of my strategy."

As mention in 1 and 2, this is not without risks, but in some cases the risk amounts to the same as buying the stock (without stops) on the downside, or not buying the stock as you wait for it to go lower, only to have it move higher without you taking a position. The strategy is worth considering, but of course, requires a little more monitoring than a simply buy-and-hold type strategy. Also, if you are looking to reduce/eliminate your downside risk, but still participate in any upward movement, call options might be a more manageable position.