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Volatility Rising? Options for Hedging the 2012 Rally

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If you've caught the explosive rally in stocks since late last year you're left with a high class problem: how can you lock in some of your gains without either incurring horrific short-term tax gains or leaving yourself out of the market when stocks are still rising?

Jon Najarian, co-founder of TradeMonster.com joins me in the attached clip to discuss some options strategies to add protection during the 2012 rally.

The CBOE Volatility Index (^VIX) has fallen from over 23 to around 18, a greater than 20% drop in 2012 alone. Despite this Najarian says the smart money players in the pits "are betting the VIX will keep moving lower." Drops in the VIX, often referred to as the "Fear Index" typically accompany benign, if not rallying stock prices. Think of options pricing as you you would think of the cost of flood insurance; when the tides are rising the price is high, during droughts you can't give insurance away at any price.

Najarian says the low prices in volatility combined with the rally make now a smart time to start using puts and calls to protect your portfolio. Nothing fancy, just a paired trades that take some risk off the table without getting too advanced or paying too much of a premium at the School of Options Trading.

Starting with the notion that he "would not hedge short-term but hedge further out," Najarian suggests looking into a couple different strategies based on what's called an options spread --buying and selling calls in the same security at different prices or times.

Najarian explains with a hypothetical trade on the VIX itself. "Buy, for instance, 25-strike calls," he offers, "then sell the 30's against it."

If the VIX rises, implying that stocks were heading lower, the gains in the 25 calls would offset some of your portfolio losses. In the event of real panic like we saw last Summer and Fall when the VIX spiked over 40, the short half of the trade would be a loser, but not with the +100% downside often associated with options shorts.

If held to expiration such a spread would get the maximum return if the VIX closed at 29.99, making the long side of the trade worth $4.99 and the short 30's worthless. Without getting too deep into possible gains and losses, the point of Najarian's trade is that you'd be making money on a market drop; easing the pain on a markdown in your core holdings and helping ease that panicky "Must... sell... stocks" feeling all too common during market plunges.

Options obviously aren't for everyone but when correctly used they can be a way for prudent speculators to enhance their returns. With markets perhaps unrealistically calm, now may be a good time to start educating yourself on options strategies and taking advantage of today's low prices on Vol.