Volatile stocks and inflated premiums | Volatility and the VIX

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Volatile stocks and inflated premiums

Option Market Outlook: 11 September 2008

Buzz surrounding Lehman (LEH) continued to dominate the news today. When I combine that with falling demand for oil, an SPX at support and a VIX outside of bearish reversal zones, it looks like there is more downside potential in the market in the short term. For options traders that means premiums are likely to stay high and volatility will continue.

In the intermarket environment, bad news from the Eurozone drove the value of the USD against the EUR. This can be seen and taken advantage of by equity traders through gold prices (check out our discussion on the gold ETF GLD here.)

All the noise about Lehman has turned a lot of traders towards investigating the stock as a potential (if very speculative) bet to the upside. All by itself that is not necessarily a bad idea but not understanding how the options market protects itself from this kind of speculation is important see today's video below for more explanation. I will show you how options prices get inflated when a stock is being crushed like this and how that compares to similarly priced stocks in other industries. The bottom line is that although a positive surprise for Lehman could send the stock through the roof, out of the money call options are so overpriced it may not be worth the ride.

Preview: 11 September 2008
With the oil inventories numbers and OPEC behind us we are not expecting a lot of interferance from energy prices. However, the financial sector is likely to continue acting like ankle weights for the rest of the market. Clearly, we are watching the sector for any news in the coming sessions, however, in light of the high level of volatility risk right now traders should be managing their investments to maintain appropriate (high) levels of diversification and coverage.

Trade numbers from the US may help buoy things up a little if exports continue to look good. However, I would not get too excited about an announcement that has a long term historical trend of delivering bad news. A couple of big names will be releasing earnings tomorrow including Motorola (MOT) which has been closing its gap from late July/early August over the last few days. Credit market constraints and a weak economy still has me biased to the downside on corporate earnings but we are always on the lookout for a surprise.

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