How To Profit From The “Fear Premium” While Others Lose Money

As a general rule, stocks tend to climb in a steady, predictable pattern. Declines, meanwhile, have a greater tendency to happen in dramatic fashion.

Of course, there are exceptions to this rule. When a pharmaceutical company announces FDA approval for a drug, or a junior mining company releases strong data on its underlying reserves, stock prices can spike higher. And there are certainly stocks that drift lower over time.

But, for the most part, stocks that are declining have much more volatility. Stocks that are rising tend to gradually appreciate in value with less volatility. This is because the majority of the investment public is biased toward the long side. When stocks move higher, most investors assume that “all is well”. Stocks that are declining create more uncertainty and fear in the market.

If you are an active trader, you should have no problem profiting when stocks decline as well as when they appreciate. We are just as happy to make money as investors panic and liquidate their positions as we are to capture gains from growth stocks on their way higher. In fact, you may find that you actually prefer making money on the short side. This is because with proper risk management and position sizing, there are opportunities to make money much more quickly as stocks fall.

But for the many investors who prefer not to sell stocks short or take on bearish positions, dramatic stock declines can still represent tremendous opportunities.

Profiting From the Fear Premium

For long-only investors, the silver lining for periods when stocks are falling is that the increase in volatility can create attractive buying opportunities. The main reason is investors have a chance to add to their investments at a lower price. And a put-selling strategy can create an additional discount for stock prices due to the “fear premium” inherent in options contracts.

The “fear premium” is a commonly used term for the increase in option premiums during times of heightened volatility. The logic assumes that traders will be willing to pay a premium price to hedge their portfolios by buying put contracts during periods of heightened risk. Due to arbitrage pressure, premiums on call options and put options must be about equal. This means that the market price of options contracts will rise during periods of maximum fear.

The CBOE Volatility Index (VIX) is a good instrument for measuring how much fear is priced into broad market option contracts. This index takes a sampling of option contracts on the S&P 500 and records the level of premium investors are willing to pay to hedge their risk (again, often referred to as “fear premium”).

Notice how the index typically spikes higher during times of maximum uncertainty and fear, such as in late 2008:

While the VIX measures option premiums for the broad market, the same dynamics occur for individual stocks and their corresponding options. So, as a general rule, when a stock falls due to uncertainty or fear among investors, not only are we able to pick up shares at a discount, we can actually sell puts to tack on an extra fear premium to our trade.

Selling Puts to Capture “Fear Premium”

Long-term investors can add extra income to their investment account and potentially buy stocks at a lower price by selling puts during times of increased risk.

Selling one put contract obligates the seller to purchase 100 shares of the underlying stock at an agreed-upon price (known as the strike price) provided the stock is trading below this level on the option’s expiration date. The seller collects a premium for accepting this obligation. And when there is more fear in the market, this premium increases.

So, as long as the investor doesn’t have any reservations about owning the stock at this lower price, the concept of selling puts can be a very lucrative way to pick up shares for a long-term investment.

Once the puts are sold, there are essentially two ways for the trade to work out. Either the investor will become obligated to buy the stock at a discount price, or the puts will expire. This allows the investor to keep the premium, which represents income for the put seller.

This approach can be a tremendous way to profit from high-risk environments that typically cause problems for investors. The next time you see one of your favorite long-term investments falling, think about selling puts. You might end up with a much cheaper cost basis or some attractive income to boost the value of your account.

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