11/21/2013 7:00 am EST
Volatility has been quiet lately even as the stock market has risen relentlessly, but option expert Michael Thomsett of ThomsettOptions.com offers a strategy for taking advantage of temporary price swings in stocks that you own.
Playing short-term volatility swings is fairly straightforward using long calls or puts. But both require you to pay money. The alternative of receiving money to play the same swings is very appealing…and it makes sense as long as the risks are well understood and manageable.
The situation arises when your long stock values rise and you expect some of the price movement to reverse and go back to the previous trading range. So do you sell and take profits now while you can? Or do you hold on through the period of volatility?
If you believe the current price rise is temporary, another alternative is to sell one covered call per 100 shares you own. If your assessment of conditions is right and the price does retreat, you can buy to close the call and take profit—without having to sell your stock. If the timing is wrong and the stock price rises, your shares could be called away. Or you can close the short call or roll forward to avoid exercise.
The same strategy is used when the price declines. If you believe the price move is only temporary, don't sell shares to cut your losses. If you sell puts instead, you get paid and if stock values do rise, you keep the premium and make a profit. The risk here is that unlike the call, the short put is not covered. So you could end up getting exercised and having 100 shares put to you at the strike. So you have to be prepared for this. But if you think the strike is a reasonable price for shares, this is a great way to play the swings using short options. You cut your risks by getting paid, and time decay works in your favor. For this reason, focus on contracts expiring in two months or less when time decay is most rapid. You can also close at a profit or roll the short put forward to avoid exercise.
Options can help manage price swings in your portfolio, without having to dispose of shares you think are worth owning for the long term—either to take profits or to cut losses. The issue is one of how to manage volatility. This is a difficult task, and many options traders can benefit by also tracking the chart of the underlying, looking for reversal signals and confirmation. This improves the timing of both entry and exit of the option position.
By Michael Thomsett of ThomsettOptions.com