The turbulence in the financial markets is a signal that investment decisions are being driven by emotions rather than fundamentals.

Stocks that post better than expected earnings are failing to hold gains. Even major takeovers announced this past year are not certain to go through. Note, for instance, the share price of BCE Inc., which is more than $6 less than its anticipated buyout price. And that is a company that is guaranteed a break-up fee of about $1 billion if the deal falls through.

Emotions are fragile, and it is clear that investors are trying to weigh the fallout of the credit crunch.

Many are wondering if the financial services sector has disclosed the full extent of its losses and what, if any, will be the long-term impact on the American consumer. In the process, anything that may be fundamentally positive is being overshadowed by these fears.

The iceberg theory is also making the rounds. Will there be significant unforeseen credit risk from segments of the market unrelated to housing?

Concerns about financing companies such as General Motors Acceptance Corp. and Ford Motor Credit, as well as other intermediaries in the automotive space, weigh on the market. There are issues around whether the rating agencies are classifying this paper appropriately. And if they are, is the market ready to trust the judgment of the rating agencies once again?

Bond insurers are also front and centre. If these companies lose their AAA status, they will not be able to insure new issues, which means that banks wanting to sell packaged debt may have to raise significant capital in order to self-insure. One estimate from London-based Barclays Capital, the investment-banking arm of Barclays Bank PLC, puts the additional costs of insuring outstanding debt at about US$143 billion should bond insurers get their credit ratings cut.

The options market mirrors the sentiments that drive trading decisions. We see that in higher implied volatilities across all sectors.

If there is a good strategy in the current environment, it is one that takes advantage of the higher than normal options premiums using a sector of the market for which there is a high degree of certainty as to the next move.

For that, we look at the U.S. government bond market. We know with a high degree of certainty that the U.S. Federal Reserve Board will cut interest rates. Daily trading in Fed funds futures confirms that, as on any given day, the futures imply a 75%-100% probability that the Fed will cut rates at its next meeting. For our purposes, lower interest rates mean higher bond prices.

Obviously, much of this has already been priced into the bond market. iShares Lehman 20-year bond index fund (symbol: TLT) recently traded at US$93.53 a unit on the New York Stock Exchange, up sharply from a low of US$82 in June 2007.

What’s interesting is that options on bonds are mirroring options on the rest of the market — which is to say the options on TLT are trading at higher than normal implied volatilities. During the third week of February, with TLT at US$93.53, the TLT March 95 calls were trading at US$1.35.

Writing the TLT options provides immediate cash flow that augments the monthly interest income paid by the iShares.

So, if you were to buy TLT at US$93.53 and write the TLT March 95 calls at US$1.35, the six-week return, if exercised, would be 3.06%. If the stock price remains the same, the return would be 1.46%. (Neither return assumes any interest payments that would be received during the holding period.)

Another approach would be to write the TLT March 93 puts at US$2. If TLT is more than US$93 — bond prices should rise as interest rates fall — at the March expiration, you will retain the premium received.

If you have clients who want to be aggressive in a much less certain environment, you could also look at bond insurers. AMBAC Financial Group Inc. (symbol: ABK), recently priced at US$8.90 on the NYSE, is one case in point.

Recognize that this is a very aggressive trade because ABK could end up bankrupt. What’s interesting is that the risk of bankruptcy is being priced into the premiums, as ABK options are trading with implied volatilities of more than 200%. It is much the same story for the other bond insurers.

@page_break@In terms of strategy, with ABK at US$8.90, you would buy the shares and write the in-the-money ABK March 7.50 calls for US$2.65. The return — if exercised and if the stock stays the same — is 20%.

The risk to the downside is obvious: the stock could go to zero. And the covered call will only protect the position to US$6.25, not including transaction costs. The strategy only makes sense if you think the company will survive.

A more aggressive approach would be to write an in-the-money ABK covered straddle. In this case, buying 100 shares of ABK at US$8.90 and writing the ABK March 7.50 calls at US$2.65 and the ABK March 7.50 puts at US$1.55.

If the stock is above US$7.50 at expiration, the puts will expire and your leveraged return is 59.57%. (Note that you are using margin to maintain the short ABK March 7.50 put.) If the stock is below US$7.50, the calls would expire worthless, but you would be required to buy another 100 shares at US$7.50. At that point, you would own 200 shares of ABK at a net cost US$6.10 (first purchase at US$8.90, plus the second purchase, at US$7.50, less US$4.20 a share in option premiums).

A word of caution: do lots of homework on ABK. Make no mistake, this trade assumes survival.

If you are recommending trades in bond insurers, do so only to your most aggressive clients and only those with speculative capital to put at risk. IE