12/28/98 THE OPTIONS GAME: IT'S UP. IT'S DOWN. IT'S O.K.

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THE OPTIONS GAME: IT'S UP. IT'S DOWN. IT'S O.K.
Buying and selling options can be a good way of making market volatility work for you
'We came back a long way in a short while,'' says Kevin L. Murphy, managing director of retail options at Salomon Smith Barney, referring to the rebound from the sharp summer sell-off. ''It makes us cautious.'' Murphy is not alone. Investors using options to protect themselves from market turbulence are pushing volumes at the major options exchanges to record levels. And considering the recent swings in the stock market, using options to reduce risk may be a good idea in 1999, provided you understand what makes option prices move.
The key to assessing options prices is volatility. The more volatile a stock or a stock index, the higher the price of an option to either buy that stock (a call) or to sell that stock (a put) some time in the future. Sure, stock charts give an idea of the range of historical price movements in a stock or stock index. But they are of limited use for divining future volatility. And determining future volatility is a big part of successful options investing. The best way of getting a fix on the size of future gyrations is to use options prices, which themselves reflect the market's volatility expectations.
The most widely followed measure of the volatility built into options prices is the market Volatility Index (VIX). That index tracks the prices of put and call options on the Standard & Poor's 100-stock index, which are traded at the Chicago Board Options Exchange. When the VIX closed at a peak of 49 on Oct. 8, the market was pricing options under the assumption that the S&P 100 index would move up or down about 49% in the next 12 months.
Those investors who had the courage to sell options at that level made the right bet, since volatility has fallen since then, and so have the prices of both put and call options, adjusting for price differences in the underlying stock. Currently, the VIX is heading back up, after falling to a low of 21 on Nov. 23 (chart), as fears about corporate earnings have increased.
How you hedge a stock portfolio depends on whether you think the options market is under- or overstating the future volatility of the stock market. If you think the market could head lower than options prices are implying, the simplest and safest hedge is to buy put options. These limit downside risk by locking in a guaranteed price for up to two years.
This kind of insurance policy doesn't come cheap. If you're holding Intel at 111 9/16, the price as of Dec. 14, an April put option to sell 100 shares of the stock at $110 would cost $900. That means the put would have been worth the investment only if Intel stock drops below $101.
''COVERED CALLS.'' If, on the other hand, you believe the market is overestimating future volatility, you can take advantage of the high premiums by selling--or writing, as they say--call options against the shares you own. These ''covered calls,'' as they are known, give the buyer the right to purchase your stock at a set price--called the strike price--up to an expiration date. This strategy has several advantages for investors. First, you collect premiums, instead of paying them out, as is the case when you buy a put option. Second, while your downside protection is limited only to the premiums you collect, you can still participate in share gains up to the strike price. ''The best time to write calls on stock positions is after a big runup,'' says Murphy.
Take Intel again. You own 100 shares. The stock has risen from 72 5/8 to 111 9/16 this year. If you think there still might be some upside but are willing to settle for a guaranteed but limited gain, sell calls. An April call option on Intel at a strike price of $120 sells for 8 1/8 a share, or $812.50 for 100 shares, excluding brokerage commissions averaging about $35. With the stock at 111 9/16, you would not be losing money until it fell below 103 7/16--a 7.3% drop. If your stock stays where it is, and the contract expires worthless, you pocket the $812.50. If Intel soars and your shares get called away, you still make $843.75 of price gains, plus the $812.50 premium. Not bad for a four-month commitment.
By Andrew Osterland in Chicago

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