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An Opportunity To Sell Expensive Options

By Len Yates

It was a pleasure meeting many TradingMarkets.com
members at the TradingMarkets 2000 conference last weekend in Las
Vegas, especially the options enthusiasts. What a terrific conference! 

At the conference I
mentioned a current opportunity in Nortel Networks. Since the opportunity is
still there (although it might have been optimal on Wednesday October 18), it
bears repeating for everyone’s benefit.

As you can see from
the historical volatility chart (below), implied volatility (IV) is 80%,
matching a six year high, vs. a more normal 40%.  This presents us with an
excellent opportunity to sell expensive options.

The interesting
thing is that Nortel’s volatilities have soared to way above normal levels on a
lot of daily price action but not so much stock movement. A look at the price
chart (below) will help explain what I mean.  Nortel held up fairly well in the
recent sell-off compared with other tech stocks. However, it’s daily price
range has been greater in the past couple of months. This high daily price
range is what caused volatility readings to spike. So this stock has been
volatile, but without really going anywhere. In other words, in a sense this
stock is not as volatile as the numbers would suggest.

All we need is for
the daily price swings to quiet down, and volatilities will come back down.  And
they have a long ways to fall — from a current IV of 80% all the way back down
to a more normal 40%!

The suggested
strategy would be a covered combo if Nortel is a stock you would like to own, or
own more of.  Here is an example using numbers I’m seeing at the close Thursday
October 19:

Buy 500 shares of
stock at 65.625

Sell 5 Nov 65 calls
at 7

Sell 5 Nov 60 puts
at 3.75

Thanks to selling
such expensive options (both of these are trading at IV=88%), we’re effectively
buying a 65-dollar stock for only 55. I explained the covered combo strategy in
a previous article. The catch is that any stock appreciation above 65 is lost
because of the short calls. You might want to sell the 70 or 75 calls instead if
you want to see more can be made from stock price appreciation. Or, just stay
with the 65’s and see some very impressive short-term returns (18% in one month
if the stock gets called away).

If you want to do
this, hurry. I doubt if this opportunity will last more than a couple of days.

 

Follow-up to previous AOL recommendation:

A few weeks ago I featured an opportunity to buy a cheap straddle in
AOL. You may close this position now for approximately a 30% gain, as implied
volatility rose from 41% to 61% in the meantime. Since we were allowing three
months for this to work, to have it pay off in just six weeks is a pleasant
surprise. For those of us who just bought calls (rather than a straddle), we’re
holding a while longer until AOL rebounds, which I think it should. I’m willing
to go on record as saying the stock market has completed its bottom. A vigorous
rally is likely from here.

A new trade in AOL looks interesting. It is a horizontal debit spread —
formed by buying the Jan02 60 call LEAPs (IV=44%) and selling the nearby 60
calls (IV=61%). This takes advantage of the large IV disparity between these
options, and sets up a bullish position with a good chance of doubling our money
in 90 days. A 10-lot costs just under $5,000 to implement. Note from the graph,
the extremely broad profit zone, even extending several points below the stock’s
current price.