Dow Jones Reprints: This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, use the Order Reprints tool on any article or visit www.djreprints.com
Options are arguably the most sensitive instruments for divining the future of stocks. The smartest stock investors dominate the options market. When they are afraid a stock may fall, they buy puts. When they think a stock will rise, they buy calls. Implied volatility, which reveals their expectations of the future, shows if they expect the stock move sharply, or not.
By dividing an option's implied volatility by 16 -- the square root of the number of trading days in a year -- stock investors can get a sense of a stock's expected movement that is priced into the put or call. The "Rule of 16," as the exercise is known, will give you a good estimate of the options market's views.
Options have more moving parts than stocks, and not everyone likes that, but a strong case can be made that everyone who invests in stocks should be a consumer of options information.
Armed with "asymmetrical information," such as the difference between implied and historical volatility levels, you can make smarter stock-investment decisions. For example, by selling puts and calls against stocks, many investors outperformed the Standard & Poor's 500 Index in 2011 (see last week's "Buy Write Is the Right Buy"). Investors who dismissed options as too complicated, or gambling, lost a year of returns.
A good question investors must ask when buying stocks is if it is possible to express the same idea -- options speak for making a bet -- for less money someplace else. Or can you get paid for expressing the same idea by selling a put or call.
If you think a stock will rise, or fall, you can probably get more bang for your buck, and risk less money, using puts and calls. That kind of thinking increasingly drives the decisions of many professional investors, who helped make 2011 a year of record trading volume for the options industry.
Many stock investors have already dipped their toes into the options market. They use the Chicago Board Options Exchange's Volatility Index, or VIX, as an indicator of fear or confidence toward the stock market. Let VIX be the cornerstone of thinking asymmetrically about investing.
A READER E-MAILED IN RESPONSE to last week's column to ask what it meant for "buy writes," the winning strategy of 2011, if VIX was low. Selling calls against stocks -- that's the buy write strategy -- works best when volatility is high because you get more money selling options.
Before I could write back, a report came in from Goldman Sachs advising clients to use options as inexpensive stock surrogates when volatility is low. "Options prices on single stocks have declined significantly ahead of earnings, as the Standard & Poor's 500 Index has risen 14% over the past three months, presenting attractive opportunities for fundamental investors to gain directional exposure, while keeping risk limited." So advised Goldman strategists Katherine Fogertey, and John Marshall.
In other words, when VIX is low, investors can use options to express views on stocks without paying a premium, and often with less money at risk.
The strategists told clients to consider buying January at-the-money straddles (puts and calls with same strike price) because the straddles are priced as if the stocks will move less than normal in reaction to earnings. Google (ticker: GOOG), for example, is priced for a 6.5% move, up or down, yet the stock has moved an average of 7.3% during the past eight quarters. Goldman likes buying Google's January $640 puts and calls. The Google straddle is a favorite Goldman trade that has an average profit of 21% and makes money about 55% of the time.
Bottom line: anything investors can do to shift the odds in their favor is worth considering.
Comments: steve.sears@barrons.com
http://twitter.com/sm_sears
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com
MySpace
Digg
del.icio.us
NewsVine
StumbleUpon
Barrons.com has identified a few large-cap companies that possess more than just a decent yield.
By Richard C. Morais Penta finally uncovers a top-rate Lebanese restaurant in New York to rival the mighty Al Hamra in Mayfair, London.This restaurant is in Bay Ridge, Brooklyn.
With the oil field service company's stock near a 52-week low after CFO Ricardo Rosa suddenly resigned, we see deep value.
Qualcomm and Broadcom will do well despite a downbeat chip environment.
The contract driller's segments will see favorable conditions.
Credit Suisse likes Cytec, Ashland, FMC and Dow Chemical.
After a significant run-up, the regional bank trades at a premium to peers.
Interpublic has made its share of mistakes. But this cheap stock has a clear path to recovery.
Though many retailers posted disappointing December same-store sales, these two retailers should bounce back.
J.P. Morgan likes Texas Instruments, Analog Devices and Xilinx.
Big banks might seem cheap, but regional banks are better positioned, say analysts.
December job upticks brought some cheer in the first week of January, but many of the jobs are the transitory type. The U.S. recovery may be quickening at last. But investors are evincing a healthy skepticism, which should help them if the pace droops again.
Though subject to brutal cyclicality, Robert Half International is rebounding in an economy where the temp worker has become a fixture. Need a part-time accountant?
Muni bonds rallied last week as institutions reinvested interest coupons and cash from redemptions and maturities of state and local bonds. Where to find good values.
Alcoa, the second-worst performer in the Dow in 2011, could rebound this year as aluminum prices bottom and mining capacity is rationalized.
Medifast, a leader in the weight-loss industry, has lost its edge and rankled investors. With rival Weight Watchers muscling up, the company's stock is on a serious diet.
Read Full Article »