More Intriguing Possibilities

  • August 7, 2001
  • Len Yates

I
sense a short-term rally coming. The reason today was
important is that the recent downward swing seemed to be gathering momentum, and
today that momentum stalled.

More importantly,
many of the popular tech stocks have refused to give much ground and are showing
a “handle.”  These include
Brocade
(
BRCD |
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PowerRating), Broadcom
(
BRCM |
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PowerRating), Network Appliance
(
NTAP |
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PowerRating),
OpenWave
(
OPWV |
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PowerRating), PMC-Sierra
(
PMCS |
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PowerRating), VeriSign
(
VRSN |
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PowerRating) and many
others.

Now, I could turn
out to be wrong about this rally, but there is perhaps a more important point to
be made —- and that is how I’m using options to play it.

Options continue to
be cheap, not only by recent historical standards, but also, in some cases,
they’re cheap in view of the current volatility of their underlying.
Case in point: VeriSign
(
VRSN |
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News |
PowerRating).
Its SV (statistical volatility) is currently 95%.
Yet its options are trading at an IV of only 68%! 
(The volatility chart below shows IV to be 76%, but in the Matrix today,
nearby options can be bought at an IV of only 68%.)


Now, consider that
you can either buy shares of the stock, or you can buy some of these cheap
options. Going with the options uses a
smaller amount of capital for an equivalent position.
It also conveys the advantage of a theoretical edge.
Not only are these options attractive because they’re cheap, but their
cheapness brings with it a greater leverage. Thus
an even smaller quantity of them gives you an equivalent position in the stock.

Say you would have
considered getting 200 shares of the stock. That
would cost $10,900 at today’s price. The
same delta (price sensitivity) could be had with the purchase of just 4
at-the-money calls at $250 each, for a total of $1000. 
That’s less than 1/10th the capital.

You might be temped
to “leverage up” and get more than 4. That’s
OK, but also realize that as soon as this stock starts to move in your
direction, the option’s delta will increase, automatically making your
position stronger (more long). Potentially,
delta could increase to as much as 100 per option — equivalent to owning 400
shares of the stock!

The story is the
same in many of the other stocks mentioned above.
If we were facing a situation where options were expensive, it would
behoove us to go long by either buying stock or deep in-the-money calls.
But right now the situation heavily favors buying (small) quantities of
at-the-money or just out-of-the-money calls.

(That is, if you
look for a short-term rally.)