As painful as the current economic environment is, options traders now have a unique opportunity to dollar-cost average their way into new positions as Warren Buffett does, take advantage of record-high options prices and buy into the market on the basis of where experts think a bottom may exist (i.e., 10%-20% below current values).

As a case in point, let’s look at NYSE Euronext Inc. (symbol: NYX), which closed at US$25.34 a share on Oct. 24. When you look at NYX’s business model, it is effectively a toll booth. Investors pay fees to trade financial instruments on various exchanges. And in this environment, exchanges are experiencing record volumes, which means more traffic paying those tolls.

It’s also important to point out that governments around the world have promised to bring in a new regulatory environment — presumably, one that would deal with the problems that caused this crisis of confidence.

At the heart of this crisis is the uncertainty surrounding the size of the credit-default swap market. These instruments trade in an over-the-counter market with no transparency, in which two entities swap loans and for which the value of the transaction hinges on the stability of the counterparties. If one side of the swap goes bankrupt, there is nothing supporting the asset.

What we have learned from this is that the OTC market is no place for credit. A better approach, from a regulatory perspective, would see CDSes, corporate debt obligations and the like trade on exchanges in which a third party acts as the counterparty with regulated capital (i.e., margin) requirements — much like the Options Clearing Corp. does for exchange-traded options.

If that becomes the new framework, much of the credit market would move onto exchanges like those operated by NYX. By the way, it is estimated that the credit market is at least as large as the stock market; in fact, it is probably three to four times larger.

So, let’s assume for this exercise that NYX continues to exist and that we will not be able to pick an absolute bottom, which is to say that dollar-cost averaging is the best way to enter the game. We can buy a little now and buy a little later. Ideally, this would result in an average price that is at least 20% less than the current market value.

For the final piece of this puzzle, we want to take advantage of record-high option premiums, which, in the case of NYX, are trading in excess of 120% implied volatility.

The strategy of choice is the covered strangle, which involves three steps. We begin by assuming you are willing to buy 1,000 shares of NYX — a little now, a little later. In that scenario, the covered strangle begins with a purchase of 500 shares at US$26.25 each (the stock’s price at time of writing ).

The second step involves the sale of five January (2010) 30 calls (these are technically considered “long-term equity anticipation securities,” or LEAPs) at US$6.25 a share. With the sale of these calls, you have agreed to sell your initial 500-share position at US$30 a share anytime up to and including the expiration date of Jan. 16, 2010.

The third step is the sale of five NYX January (2010) 25 puts at US$7.50 a share. With the put sale, you are committing to buying 500 additional shares of NYX at US$25 a share until Jan. 16, 2010, the expiration date.

Conservative investors may want to set aside additional capital in a U.S.-dollar guaranteed income certificate that matures in January 2010 to provide for the possibility of having to buy the 500 additional shares should the puts be assigned. Think of the puts as the option market’s version of dollar-cost averaging.

Having laid out the strategy, what does it offer in terms of a best- and worst-case scenario? To establish that, we begin by calculating the per-share cost of the original 500 shares. The initial 500 shares of NYX cost US$26.25. However, you immediately received US$13.75 a share from the sale of the options (US$6.25 from the calls plus US$7.50 from the puts = US$13.75), which means your initial capital outlay is US$12.50.

Remember, the short calls oblige you to sell your initial shares at US$30 each. The short puts oblige you to buy an additional 500 shares at US$25 a share. What we know with certainty is that only one of the options will be exercised. In fact, there is a possibility — should NYX close between US$25 and US$30 in January 2010 — that both options could expire worthless.

@page_break@The best-case scenario would see the stock above US$30 a share by the Jan. 16, 2010, expiration. In that scenario, the call will be assigned and the put will expire worthless. You will deliver your 500 shares to the call buyer and the trade ends. The return on your initial outlay is 140% (US$30 sale price from the call divided by the US$12.50 initial outlay, subtract one from the answer, multiply it by 100 = 140%).

The stock could also fall between now and Jan. 16, 2010. If the stock falls, the NYX 25 puts will be assigned and you will be required to buy an additional 500 shares at US$25 a share. In this worst-case scenario, you would end up with 1,000 shares of NYX at an average per-share cost of US$18.75 (US$12.50 a share initial outlay plus US$25 for the second block = US$37.50; divided by two = US$18.75). This is considered the downside break-even price.

In the worst-case scenario, we have taken advantage of dollar-cost averaging and end up with stock at an average price that is 28.5% below the current market price. Thus, taking into consideration expert opinion that says we could see 10%-20% further downside, Warren Buffett would be proud. IE