With market volatility picking up over the last 6 weeks, it’s really important to make sure your trading toolbox is ready to profit from whatever the market throws your way. While many newer traders are focused on playing market upside exclusively, experienced traders know that there is actually more opportunity when markets head lower. This is especially true for options traders. Why is this the case? When markets head to the downside a number of things happen. First, volumes typically pick up making it much easier to get in and out of trades. Second, when markets head lower the volatility typically picks up. When volatility picks up it really opens up our playbook giving us more strategies to use. This allows us to put on trades that increase our chances of success. As an active options trader, when I see price extremes along with volatility expanding I know it’s time to really ramp up my trading. Let’s walk through an example of what I’m talking about.
Over the past 6 weeks we have seen a number of stocks get beat up leaving many names at price extremes on the downside. When this happens, I often like to take advantage of the price extreme by playing for a bounce higher. If this is the case, does that mean I step in and buy shares of stock? The problem with that approach is I am limited to making money only when the stock bounces higher. If it goes sideways or even lower then I will lose money. The better route to go is to look into our options playbook to see which strategies will increase our odds of success.
One trade type that will increase our odds of success when trying to play the bounce higher is a short put spread. The short put spread is also known as a short vertical spread. Initially, when you see put options being used often times people think the goal is to play the downside. In this case, since we are selling a put spread to open a trade it’s actually a bullish position. One example of selling a put spread to play a bounce higher can be seen on FCX which is Freeport-McMoran. Back in August, we looked at the chart of FCX and saw that it had seen a big move to the downside leaving it at what we thought was a price extreme. We also saw the Implied Volatility on FCX options jump to high levels. To play a potential bounce higher, we actually sold the September 10/9 put spread. This position is put on by selling the September 10 put and at the same time buying the September 9 put. By making this a spread the trade ends up being a fully hedged position. We sold the trade to open the position for .41 or $41 per spread. This $41 is the most we can make on the trade. Our risk is limited to $59 per spread ($1 difference between the 10 and 9 strikes – .41 credit received).
While the risk to reward on this trade doesn’t look promising (risking $59 to make $41), there is actually a number of reasons which make this position appealing to me. Since we are selling the put spread to open, the position will put time decay in our favor. Most traders are programmed to buy options which means time decay is working against you. In our example by putting time decay on our side we are actually going to make money from that time decay for each day that we hold the trade. We also make money from Implied Volatility moving lower. This would make the options get cheaper faster as Implied Volatility is a big input in the options pricing model. So we are already giving ourselves multiple ways of making money. However, it gets even better yet.
If we are trying to play a bounce higher in FCX, then by selling a put spread to open the trade we are still looking for the stock to move higher. That is the ideal scenario for us. What if we are wrong on price direction though and FCX doesn’t move higher? We actually have some wiggle room to be wrong and still make money. We sold the September 10/9 put spread for .41. That means our breakeven point is at $9.59. As long as FCX stayed above $9.59 per share we could make money. When we put the trade on FCX was trading for $10.25. This meant FCX could move lower and we still would have made money. We could have been dead wrong on market direction and still make money! We all know stocks can move higher, lower, or go sideways. In the case of our put spread we could potentially make money in all 3 market moves. So instead of buying shares of stock or buying a long call to play a bounce higher, which would only profit if FCX moved higher, we were actually giving ourselves multiple ways of winning on the trade.
Fortunately for us we did get a move higher in FCX which meant the put spread that we sold got cheaper. We ended up buying the spread back to close the trade for .10, which gave us a profit of .31 or $31 per spread. This gave us a great profit with very little risk. The main point here is to see that instead of placing a trade that only wins in one market scenario (long stock or long call option) we actually put on a trade that would have won in 5 different scenarios (stock higher, lower, or sideways, time decay, and Implied Volatility going lower).
To become successful in the market long term you have to make sure your playbook is ready for whatever the market throws your way. By having access to different options strategies we are able to place trades that increase our odds of success. We are taking the numbers and statistics and placing them in our favor. With global market volatility picking up, now is a perfect time to learn how to profit from the volatility with strategies like the short vertical spread.