Today's Trading Lesson From TradingMarkets

Editor's Note:
Each night we feature a different lesson from TM University. I hope you enjoy and profit from these. E-mail me if you have any questions. This lesson goes back a few years, but the important part is the strategy.
Brice
PS To learn professional options strategies, try the TradingMarkets Options College.

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.