Options Tuesday: Buy/Write Bonanza

The credit crisis has produced some amazing possibilities to take some hedged risk. We're talking about buying some of the headline losers, with the hope they'll be slightly higher at January expiration. That's 144 days, a little less than five months. It's a couple months longer than we like to hold buy/writes, but we'd like to give the market some extra time to recover - especially these headline issues.

The possible returns are quite attractive. First let's look at Countrywide Credit (CFC), the poster boy for this decline. Will it survive? The stock closed at 19.91 on Tuesday. with an option implied volatility (IV) of 70. Right now the stock is 97% below it's 90-day mean and 41% below its 10-day mean. In other words, it's at the bottom of an expected distribution that's simply massive. Lots of risk has been wrung out here.

Say you buy CFC and sell the Jan 22 1/2 call (CFCAX) at 2.20, today's closing bid. You'd make 13.7% on your money if the stock closes at the same price (19.91) on January expiration day (static return). If the stock is above 22.5 at expiration, you'll clear 32.4% (called return). And you experience no loss if the stock is above 17.71 at expiration-day close (downside protection).

To take more risk, sell the Jan 25 call (CFCAE) at today's closing bid of 1.50. Now you're looking at 9.3% static return, but you're called return has risen to 41.2% . Your downside protection is only to 18.41. We like the stats on the 22 1/2 trade better, but it's your money and your risk decision.

Next let's look at the two weakest home builders, Beazer Homes (BZH) and Lennar (LEN). Both are around 80% below their 90-day mean prices, and both are around 60% below their 10-day mean prices. One difference: LEN carries an IV of 53 -- quite elevated -- but BZH options trade at an incredible IV of 114. (Yes, it's possible to go above 100% expected volatility because IV estimates are lognormal.) So even though the two issues are about the same on the Implied Risk scale, one has twice the expected volatility of the other. Clearly, the market doubts whether BZH can survive this crises.


Here's how the possible profits look. Buy LEN at today's close of 27.33 and sell the Jan 30 call (LENAF) at today's closing bid of 2.65. That's 29% static return and 57.5% called return. Not bad, but it requires the stock to gain about 10% by January expiration. You're protected down to 24.68.

If you buy BZH at today's close of 8.88 and sell the Jan 10 call (BZHAB) for today's closing bid of 2.05, you can make about the same amount as the LEN trade on about half the percentage move in the stock. Static return is 32.9% and the called return comes to 49.3%. You've got protection down to 6.83, which represents almost 25% of the value of the stock.

Here's one more set of possible trades from the Implied Risk Buy/Write List, which looks for possible buy/writes from among the weakest stocks in our 2,000-issue database. The bond ratings services have been crushed, probably because they fear lawsuits. Oh yeah, we almost forgot, they'll also be missing all that income from rating sub-prime bonds.

Fist, let's check out McGraw-Hill (MHP). The owners of Standard & Poor's appear to be diverse enough to weather this storm. At 35, the stock's IV is high but not incredible. Buy the stock at today's close of 49.23 and sell the Jan 55 call (MHPAK) for today's closing bid of 2.25. Your static return comes to 13.2%, while your called return maxes out at 44.4%. Downside protection is 4.5%. Not a bad deal.

Then there's Moody's (MCO), which is more dependant on its ratings services than MHP. The stock closed at 44.83 on Tuesday. Buy the stock at the closing price and sell the Jan 50 call (MCOAJ) for Tuesday's closing bid of 3.30. Your static return is 20.6% and your called return is 52.2%. Downside protection is 7.3%. MCO has an IV of 49, significantly higher than MHP's IV of 35. Take more risk, make more money if you're right.


We like all these trades. We prefer using this strategy on stocks that are lower priced, under the theory that these companies aren't going out of business. That's the big question with BZH. The home builders offer the largest gains, but the ratings services probably have a better chance of giving you their max gains. CFC has some big backers, and should profit from any rate cuts.

Pep Rally in the Gym this Friday

Look for a big rally on Friday, after Bernanke practically tells the market he's going to cut rates on Sept. 18. That should bring long-term debt vehicles and short-term debt vehicles back in line with each other again. Here's why it'll happen:

There's lots of worry over short-term debt right now. That's reflected by the 13-Week Interest Rate (IRX) index, the shortest term yield vehicle we can get implied volatility (IV) from. On a 10-day basis, IRX is 144% -- let's say four standard deviations -- above its mean. It's even worse than that, though, because IRX IV has soared to the unheard-of level of 44. So short-term yields are rising crazily, meaning short-term bonds are falling.

The longest term yield vehicle we follow -- 30-Yr. Interest Rate (TYX) -- is going the other way. On a 10-day basis, TYX is 79% below its mean. TYX is about the same on a 90-day basis, more than two standard deviations below it mean. So long-term yields are heading down, which means long-term bonds are rising.

Those short-term yields are out-of-whack. Nothing you can trade, because the point movements are so slight due to single-digit IVs. But these are serious spreads that are going to attract the Fed's attention.

The Fed's goal will be to preserve the value in the short-term paper that investment banks are holding. Once we get past the next two or three months, this asset-backed paper will have expired. And it isn't coming back for a while. That's why the longer term bonds are stronger. The Fed will deal with replacing that short-term debt next next year. First things first.

With the downgrades today from Merrill Lynch, this could be a nice upside trading opportunity for the broker/dealers. Broker/Dealer (XBD), after a tepid rally, is slightly better than two standard deviations below its mean on a 90-day basis. The index will rocket back up above 90-day neutral if the Fed says it will cut. We'll short the index again in Zone 6.