Chris Tyler, Optionetics.com
March 15, 2011
Fearing repetition and to be quite honest, not enjoying having to pen about other people’s earth shattering misfortunes; it’s enough to say the market could be setting up for a short-term, playable bounce. With Tuesday’s selling pressure in the likes of the SP-500 (SPY), the major market proxy has corrected a full -6.00% at session lows while pulling all the way back to the year-to-date, January 1st unchanged mark.
Confirming that action as a potential short-term extreme, the CBOE Volatility Index ($VIX) flashed a strong sign of being overbought and overly-fearful today. While the historically well-watched 30% level hasn’t come into play, session highs of 25.72% did stretch about 25% above the mean-reverting instrument’s 10-day simple moving average.
Historically, differentials in excess of 15% have proven to reflect extremes and subsequent reversal points for the VIX as investor panic (or complacency during times of investor rapture) works itself off towards more normalized levels. When this occurs, traders can expect the broader market will swing or reverse counter to its own extremes.
Using the VIX in this capacity is first and foremost a short-term tool as the trader is looking for confirmation from a signal generated off a short-term moving average. While sturdier intermediate moves may follow, that’s really beyond the scope of most signals associated with this kind of “stretch” between the VIX and its 10-day simple moving average.
In saying that, shorter-term bullish positioning with options are well-suited for this type play, which in conditions such as Tuesday’s; amounts to playing a technical bounce within an oversold market. With the SP-500 the broadest US benchmark index, it’s an easy choice for any would be bulls to use. “If” and that can be a big one at times, “if” the market does move higher; you don’t have to worry about company specific news entering the picture and foiling a prescient call on “market” direction when you make this trade with the SPY.
Again, as the signal is a short-term / fast money play, the SPY also maintains the benefit of weekly contracts. Right now, traders have the choice of using the regular March contract which expires in three trading days or its Q1 March contract with expiration 16 days out.
The other bonus of using the SPY is strong liquidity provision. Depending on just how muscular or limited of a bounce the trader might see as forthcoming; the trader may want a more creative spread strategy versus a simple purchase. Remember, during times like these, buying this type of short-term premium can be more risky due to those options being extra sensitive to theta, as well as the higher implied prices inherent in the market as the trade is placed.
Figure 1: SP-500 (SPY) March Long Call Condor
Of course traders could always sell a put to remove risks like theta and vega. However, that kind of naked position does open up the specter of larger-than-expected risk if the trader is wrong. In appreciating Tuesday’s out-the-gate pressure, hopefully that point is appreciated enough to warrant seeking another type option such as a spread. On that note, an “At” or OTM bull put spread or its equivalent ITM bull call spread could be considered.
If you’re a bit more like me and sense a situation where the upside is truly contained in the very near-term and wish to have even less dollar risk at stake; a strategy such as a long call condor might be considered. Looking above and to illustrate, is a 6 x (regular) March 128 / 129 / 130 / 131 call condor. Sized at less than 1% risk on a hypothetical portfolio of $20K, there’s no guarantees this particular type condor will work, but I do see the fast money trade as operating more smartly nonetheless and all things considered.
Senior Options Writer, former Market Maker & fulltime Option Hedge Hog Advocate
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