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By Jason Stipp and Erik Kobayashi-Solomon | 06-06-2012 10:30 AM

An Option Recipe for Volatile Times

Depressed stock prices and increased market volatility can be a great combination for income-seekers to sell puts, says Morningstar OptionInvestor editor Erik Kobayashi-Solomon.

Jason Stipp: I'm Jason Stipp for Morningstar.

As the stock market continues to get buffeted by weak economic data here in the U.S. and continued eurozone concerns, we're checking in today with Erik Kobayashi-Solomon--he is the editor of Morningstar OptionInvestor--to get a lay of the landscape on volatility and where there may be some opportunity for investors.

Thanks for joining me, Erik.

Erik Kobayashi-Solomon: Thanks for having me.

Stipp: Over the last few weeks we've gotten a lot of headlines showing continued concerns out of EU now coupled with some weak U.S. economic data.

What has the market been doing as far as the volatility? Can you give us a lay of the land recently, and then how that's compared maybe to the year-to-date?

Kobayashi-Solomon: Actually, I've been talking on OptionInvestor for the last six months about the precarious situation we're in in Europe, and what a quarter-hearted recovery--that's a half of a half-hearted recovery--we've had in the United States.

And so I have been advising people to take a look at buying protective puts. Recently, the prices for puts implied volatility has been low on the Index. ... The VIX is the measure of implied volatility for the S&P 500. It's been trading well below its average value, its long-run average value. Even two months ago, it was trading well below the average value of 20%.

Now, we've shot up--we are up around 24% implied volatility.

Stipp: So, I know early in the year the markets were doing really well. Volatility can mean obviously upside and downside volatility. You said that it shot up recently, but just a couple of months ago it had been lower.

... How has the volatility been reacting to the stock market, the ups and downs we've seen?

Kobayashi-Solomon: Just in general you can think of a chart of the VIX and a chart of the S&P as being like a mirror image. As the S&P is going up, then the VIX is going down. This means basically that insurance is just getting cheaper. Insurance on the S&P 500 is getting cheaper.

Last year, when Europe was going through some real travails, the volatility shot to the moon. We came back a lot after that. Of course, the strong market rally since October of last year has brought the VIX down. And we've only started to head back up now.

Stipp: And the options can also give you a sense of what the market is expecting for future S&P values. When you look at it today, what is it implying about where the market expects the S&P to end up?

Kobayashi-Solomon: This is a great question. It's a question that a lot of people forget when they are thinking about the VIX. Basically what the VIX is telling us is, where is the S&P going to be in the next six months? Where is the S&P going to be in the next year?

So, I just drew the data this morning and took a look, and in one month the market is expecting a range anywhere from, let's say, 1,201 to about 1,375. In three months, that's looking out at the next quarter, we're looking at 1,143 to about 1,445. And then six months from now, that's half a year away, anywhere from around 1,088 to 1,516.

So basically, we're looking at more of the same, up and down, kind of a saw-tooth-shaped market.

Stipp: So obviously the more volatility we see, the bigger that potential range of outcomes for the S&P 500 becomes.

Kobayashi-Solomon: Yes. That's right.

Stipp: So, when you are looking, then, across the option marketplace as an investor, what does this kind of volatility imply about where you'll find opportunity?

Kobayashi-Solomon: Well, I'm glad you asked that, too. Most people when they hear volatility, they think "Oh no." But when I hear volatility, I think great--opportunity for covered calls.

What we're seeing right now, especially in basic materials, especially in energy, and in some industrials, we're seeing depressed stock prices, and we're seeing greatly increased volatility. This is the perfect combination for selling covered calls or another closely related strategy, which is selling puts.

Stipp: So, can you walk me through an example of how a covered call would work if I chose to sell a covered call on a specific name? And then how does that work out for me as an investor? How does that make me money?

Kobayashi-Solomon: Sure. Let's think about ArcelorMittal, which is a steel company, has a lot of exposure to Europe. People are very worried about it, and it's trading right now at hugely depressed levels.

When a stock is falling, when people are very worried, they are paying a lot for insurance, they are paying a lot to insure the downside. When you sell a covered call, what you're doing is taking the role of, let's say, an Allstate or a GEICO--you are the insurance company. You're saying, look, I promise that I will buy this company for this strike price, this price, sometime in the future.

For a short-term investor, that's a very scary thing to do. For somebody with a longer-term perspective, they say, "Well, gosh, this thing is trading here. It looks like it can trade two times that or three times that. So, I don't mind promising that I'm going to buy it at all." What you receive from that is a very strong income flow.

Stipp: ... in the meantime. So then, if you end up owning the stock, you are not unhappy because you expected that its value, in the longer term, will go up. And you collect that insurance [premium] in the meantime.

Kobayashi-Solomon: The premium. That's right, exactly.

Stipp: So, a great way to maybe generate some income as you're executing on an investment idea that you already had.

Kobayashi-Solomon: As I like to say, it's a heads you win, tails you win.

Stipp: All right, Erik, thanks for joining me today with that volatility and option overview, as well as the specific investment ideas.

Kobayashi-Solomon: Thanks so much.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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