Why Investor's Should Make Friends with Fear

In this post I will give some advice on why I believe investor's should become friends with fear, and explain how it can be done using stock options. I'm certain many of you already know how the markets gauge fear, but for those of you who don't, a simple way to see how fearful the markets are is an indicator called the Volatility Index [VIX]. The entry symbol to track the VIX is different in almost every brokerage I use, so a sure and easy way to track it is the Ipath S&P 500 VIX Short Term ETN (VXX).

Historically anything above 30 on the Volatility Index is high and signals increased levels of fear in the markets, but for those tracking market volatility using the VXX it looks to be the 24-25 level.

So why should investor's make friends with fear? First it is very important to note that fear is friendly only to an investor which is well educated in stock options. Why? A major factor in pricing an option premium (or contract price) is volatility. Keeping all other things constant, higher volatility = higher premium. This means investor's can sell premiums to cost average down a position, or what I like doing in times of market correction... Selling "naked puts" to get into shares I don't mind owning.

With the VIX soaring to new 52 week highs in the past week, I have been selling premiums on out of the money options on stocks which I wouldn't mind owning. I do have to note that in my last post How I'm Buying Into the Market Correction I closed almost all of the positions the following trading day which was Monday May 10, 2010, even after stating I had sold the puts as an investment and not a trade, but a move of 400+ on the Dow signaled TAKE PROFITS and easy ones were taken. With just 2 trading days left until May options expire there is still some "juice" left in many stocks which I wouldn't mind owning if they were put to me Friday. Below is a list of stocks I am looking at selling puts on, the strike prices, and the per contract premium I would receive as of close Wednesday May 19, 2010.

Company/ETF	Ticker	Strike	Premium	Adjusted Price
SPDR Dow Jones Industrial Average ETF	(DIA)	100	$20	$99.80
SPDR S&P 500 ETF	(SPY)	107	$24	$106.76
PowerShares QQQ Trust, ETF	(QQQQ)	44	$8	$43.92
United States Oil Fund LP ETF	(USO)	33	$33	$32.67
Financial SPDR ETF	(XLF)	14	$4	$13.96
Technology SPDR ETF	(XLK)	21	$5	$20.95
SPDR S&P Metals and Mining ETF	(XME)	48	$30	$47.70
Apple Inc.	(AAPL)	230	$20	$229.80
American Express Company	(AXP)	39	$30	$38.70
Bank of America Corporation	(BAC)	15	$4	$14.96
Citigroup Inc.	(C) *	3	$4	$2.96
Caterpillar Inc.	(CAT)	57.5	$26	$57.24
Cisco Systems, Inc.	(CSCO)	24	$18	$23.82
Ford Motor Company	(F)	11	$7	$10.93
General Electric Company	(GE)	17	$13	$16.87
Corning Incorporated	(GLW)	17	$11	$16.89
Google Inc.	(GOOG)	460	$40	$459.60
Goldman Sachs Group, Inc.	(GS)	130	$25	$129.75
Intel Corporation	(INTC)	21	$10	$20.90
The Coca-Cola Company	(KO)	50	$4	$49.96
Pfizer Inc.	(PFE)	15	$3	$14.97
QUALCOMM, Inc.	(QCOM)	35	$10	$34.90
Sirius XM Radio	(SIRI) *	1	$5	$0.95
Visa Inc.	(V)	70	$72	$69.28

*Indicates June options expiration.

Before selling any puts naked, I always make sure I have enough cash to purchase the shares. I won't be in any rush to sell premiums Thursday because as of 2 AM (EST) futures are slightly under pressure, but once I get the feel of the market I will begin selling premiums on many of the stocks/ETFs outlined in the table above. It is also possible (and likely with the high volatility) that I will be adjusting strike prices according to the market.

The ideas outlined above are bullish strategies and should not be considered if you think the stock will sell off in the near future. However if you feel the stock could move higher or slightly lower in the near future, this strategy could yield a nice gain. Selling puts "naked" is a very risky strategy and should not be considered with stocks one does not plan or want to hold long in their portfolio. To get a better understanding of stock options and different option strategies please check out my Simplified Stock Option Trading E-Books.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last five years is because they are a great way to hedge your portfolio as well as create income off of your shares (see chart here). Keep in mind when using this strategy it is essential that broker commissions are low enough to profit from the position.

In conclusion I wanted to briefly explain to investor's that something good can be made of fear. Remember fear or volatility brings increased option premiums, therefore if shares fall and are put to an investor on May options expiration, volatility will likely increase or stay the same and option premiums will still be high for June options expiration. Therefore June call options can be written against the shares to sell them at a specific price for an increased option premium as well... But that's an article for another day.

Disclosure: Long BAC, C, F, QCOM, V, GOOG January 300 Calls, Short SIRI June 1 Puts

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