Selling options in the current environment promotes flexibility, allows the trader to better withstand volatility in the marketplace, and is a much better strategy than trading equities or futures outright.

The newscasts this week are full of contradictory reports and editorials. Days the markets are down, doom and gloom abound. When the markets rise, the worst is over—happy days!

Some of their points are valid, while others are simply for shock value. I think there are a couple of key points remember as we navigate our way through this.

First of all. I do not believe we will have a repeat of 2008 here in the US. The major subprime, de-leveraging, and balance sheet issues of our “Too big to fails” have begun to be addressed. In other words, here in the US, the fumigation process has begun.

Overseas, they’ve just begun to turn on the kitchen lights. They’re no longer able to assume that the only roach they see is the only roach they have. As a result of their shared economy, we’re watching the blame game while they assess responsibility for their problems. This is most clearly seen in the Societe Generale (SCGLF) liquidity rumors of last Wednesday’s trading, followed by the instant questioning of the rest of the Eurozone’s banking heavy hitters like Royal Bank of Scotland (RBS), Deutsche Bank (DB), and Barclays (BCS). Does this remind anyone of Shearson (Lehman Bros.), Goldman Sachs (GS), AIG (AIG), etc.?

Traders choosing to participate in these markets may want to participate in the options market rather than directly in the equities or futures arenas. Options allow market participants to trade a general idea, rather than actual chart points. Being able to trade the idea allows us to withstand a higher degree of volatility while still maintaining our general investment thesis.

See video: The Stock Replacement Option Strategy

The two primary variables in an options price are time to expiration and volatility. Time to expiration is obviously a linear component. The more time there is to expiration, the greater the opportunity there is for that option to pay off, and thus a higher premium must be paid. Thinking in insurance terms, a policy written for 12 months would have twice the probability of a claim written for six months.

The non-linear variable in the option pricing equation is volatility. The more a market moves, the more volatile it is, and thus, it is more likely an option will end up in the money. Insurance terms say a policy sold to someone with an excellent driving record is less likely to require a payout than a policy sold to someone with a history of moving violations. The unpredictability of the second driver is the same as option volatility.

Option trading, as it equates to insurance, can be seen in two ways. A trader can write the policy, which is a calculated assumption that the policy (option) won’t be collected on, or the policy (option) can be purchased because a trader feels that there is a good chance to observe a collectible incident. The option buyer expects the driver to have another accident, while the option seller expects the driver to be on their best behavior.

Volatility increases the option premium, which makes the policy more lucrative to sell and more expensive to purchase. I have been focusing on selling options, as we’ve declined dramatically and I feel that we are more likely to rebound than we are to decline another 20% in the next couple of weeks.

In other words, I expect the market to shape up its act rather than behave as wildly as it has.

The math works like this: September S&P options expire on September 16. I can sell an option and collect $450 on a $4,000 investment (per contract) based on the notion that the S&P will still be above 900 in one month. Depending on when you look, this is another 20% lower than where we are today and more than 33% off the July highs.

Finally, should the market rally, I can always offset the position prior to expiration for a smaller profit, and if the market does tank, there are trading methodologies that can be employed to hedge my risk on the way down just like the re-insurance markets that the big boys use on their policies.

See related: When to Favor Options Over Stocks

By Andy Waldock of Commodity and Derivative Advisors

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