What a wild market we've seen. Volatilities reached levels not seen for 5 or 6 years. The Dow was down almost 800 one day and up nearly 500 by the close of the following day. These have been hard, fast swings and they can be very difficult to trade. Straight directional trades have been dangerous. What can a trader do in circumstances like these to protect himself or herself? In "Trade Your Way to Wealth" I described some strategies that can save the day in circumstances such as these. I personally use protective puts to "insure" stock positions at times and I often place collars on high priced stocks. Collars, as I describe in the book, can even be set up with zero risk and even with an assured profit at entry. As an example, back in June, I bought shares of Baidu.com (BIDU) at just over $323 a share. A couple of days ago, I sold the stock for $230 a share. It had gone down more than $90 a share, but I made a profit overall. When I bought the stock, I also bought the $320 puts and sold the $340 calls. The call premium just about paid for the puts I bought. Between June and the end of September, I bought back then resold calls against my position about 7 times, making a profit on the individual trades each time. When I closed my positions, though I took a big loss on the stock, I realized a big gain on selling the protective puts. In these transactions, I initially used the premium I was paid for the call to pay for the protective put. Thereafter I traded the calls depending upon movement in the stock price to achieve an overall gain from the stock and option trades.

I describe the BIDU collar to illustrate that there are strategies by which we can protect ourselves on the one hand and earn good profits even when we are in a market that is as wildly unpredictable as our current situation. In order to accomplish those trades, we need to acquire the knowledge. I cringe to think what may be happening to the fellow I recently wrote about who was going to learn by doing. I have no doubt that recently he has learned quite a lot about what markets can do. Circumstances like those we have been experiencing can provide a much more costly education than what one may pay to buy a good trading book, or a DVD, or a seminar, or for private coaching.

Another way to work wildly volatile markets such as those we have seen recently may be to sell option premium. When implied volatility is high, that means that option prices are high relative to their norm. Selling options to open a position when prices are high and then buying later to close the position after volatility has dropped and some time has passed can lead to some very profitable trades. The trader, for example, could do that by selling naked options with the risk attendant to those strategies or he can sell spreads (though they somewhat negate the high volatility) for pretty decent potential returns on a specifically limited risk.

Investors who are not familiar with volatility trading or who don't know how to place and trade collars or who don't understand or won't buy protective puts may best be served by remaining on the sidelines until volatility diminishes. I always remind myself that being in cash is a position, too. Depending upon your level of knowledge and individual risk tolerance, that may not be a bad place to be when volatility is soaring.

Good Trading!
Bill Kraft

October 4, 2008

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