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How to use options to play for a bounce after a brutal sell-off

Managing market mayhem

The Dow is surging back on Wednesday after plummeting about 2,000 points to start the week. Just a day after explaining how to insure your portfolio against a brutal sell-off like this, Optimize Advisors President Michael Khouw has some keys to playing this bounce without getting burned.

"In situations like this, where much remains unknown, you don't want to run out and catch a falling knife. So, we're not advocating, necessarily, going out and buying stocks with whatever excess cash you have, or using any leverage to do so," Khouw said Tuesday on CNBC's "Fast Money."

The downside risks of buying stocks outright in a volatile environment like this are self-evident, but as Khouw would point out, there are certain risks to avoid when using options, as well.

"Another point I would make is, try to avoid double exposure. So, if you're going to do things like sell puts because premiums are elevated, don't do so in companies that might be exposed to a great deal of risk. Examples of that would be travel, airlines and energy stocks," said Khouw.

Especially if you aren't interested in liquidating your entire portfolio, an important thing to remember is that making an upside bet can still be used as insurance on your equity positions.

"I was looking at Microsoft and some of the ways that we could take advantage of the fact that volatility is a little bit higher," said Khouw. "One of the ways you could do this if you already own the stock and are thinking that you want to have more more exposure to the upside, but don't want more exposure to the downside, is using a one-by-two call spread."

"In this trade, you would buy the 175-calls, those were trading for a little over $5, and then sell two of the 185-calls for about $2.15. Net-net, you're spending about $0.95," said Khouw.

This trade against a long equity position in Microsoft allows you to profit directly from the trade if the underlying stock price is anywhere between $170.95 and $194 between now and April expiration. If this trade were to be put on without long equity exposure in the stock, losses would be incurred if the stock rose above $194, because the second short call would be uncovered instead of being covered by an existing long equity position.

However, if you're not already in a name that could be due for a bounce, there is a way to play for upside and still win even if the stock falls lower.

"Another thing you could do, if you don't already own the stock, is something called a call spread risk reversal," said Khouw. "In this situation, I was looking at selling the 155-puts, and buying the 175-calls, and selling the 185-calls. You can do that for even money."

In this trade, you get exposure to profits if Microsoft rises above $175 per share, with profits capped at $185 per share, meaning you can make up to $10 per options contract. If the stock falls, you're not forced to own the stock until it falls below the $155 level.

"That represents a better than 20% decline from the peaks that we saw not that long ago," said Khouw. "So, [this trade is] a way that you can get exposure to the upside without going out and buying the stock right here, and you're taking advantage of the fact that premiums are elevated."

Microsoft was trading about 3% higher on Wednesday.