Options Trading for Volatile Markets

By Michael Sabo ISSUE 712 | December 2008

When the stock market was in meltdown mode in October, Warren Buffett gave this advice to investors: “Be fearful when others are greedy, and be greedy when others are fearful.” That makes a lot of sense as a way to approach trading given the environment we are in. People are afraid, and the media is playing into this. I would like to share some general options strategies to take advantage of the volatility we are seeing in the markets.

We’ve seen a lot of professionals lose considerable amounts in the markets and smaller investors are afraid to take new positions, even if they represent good opportunities. In my opinion, we are going to continue to see this type of market volatility for quite some time. There are appropriate strategies that can offer you potential to take advantage of market moves and give yourself a little more peace of mind so that you aren’t knocked out of the market amid the day-to-day noise. Let’s go through a few examples of options strategies that you can pursue if you’d like to speculate on the markets, but would like to manage some of your risk when the environment is highly volatile.

Let’s say you are a futures trader, and that’s how you primarily have traded. Let’s assume you are not a day-trader and want to maintain a long position in the S&P 500 futures for a move higher in the coming weeks, but because price swings are large and frequent, you are not able to sustain your position. You are getting stopped out too quickly.

Futures with Options

One strategy you can pursue is to use futures as your primary position, and add options as a type of hedge. Suppose you wanted to buy S&P futures on November 20, 2008, when the market was trading under 800, but you were worried the market may not have hit a bottom yet. You could go long a December futures contract, and then buy a December put option. Which strike do you choose? That depends on the size of your account, and how well you want to be protected on your futures position. You can buy a put closer to the money, perhaps a 750 put or a 700 put, or even go further out. By buying the put, you own the right to sell the December S&P at a specified price.

If you had just put a stop in with your long futures position, you aren’t guaranteed to get out at your stop price. You might not get filled at the price you want. The market can move through your stop, or even gap considerably lower and you’ll be out of your position (and possibly out a lot of money too). If the market then rebounds sharply, you are no longer in the trade. You can’t realize the benefit of being correct about the market’s longer-term direction, because you were off in the timing. You can do the opposite type of trade too if you are bearish the S&P; you can sell futures and buy a call. There are different variations of these strategies I am going to outline that you can apply.

With the put option, you aren’t out of your trade if the market changes direction and moves lower. You are using the put as a risk management tool in conjunction with the futures position; you’ve locked in and calculated your risk while taking advantage of potential upside on the futures contract. You do have an “insurance cost,” which is the premium you pay for the option. However, you might also benefit from lower margin rates, as the exchange recognizes this hedge, and you might be able to trade on what’s called SPAN margin. Please call me for more details on how that works.

Strangles and Straddles

Some people are thinking stock indexes look at or near a bottom right now, and some commodities markets that have taken a hit in the past few months may be bottoming too. However, bottoms (and tops) are hard to pick, and no one can be sure exactly when the trend will reverse. One strategy you can pursue in this case is to buy strangles. You would buy out-of-the money puts and buy out-of-the-money calls to take advantage of market volatility. You would be long one put option with a lower strike price, and long one call option at a higher strike price. Your defined loss is the total premium paid for the call and put options, while your maximum potential gain is unlimited no matter which direction the market moves. You don’t care if the market rises or falls, you just want it to make a large move one way or the other.

I’ve also been a fan of selling strangles and collecting premium, and that can be a viable strategy for some investors if you have a high risk tolerance (which is potentially unlimited). However, buying strangles might make more sense if you want more calculated risk or have more limited funds, given the environment we are in.

Another strategy you can consider if you think the market is going to be volatile is to buy straddles. You would buy a call and a put with the same strike price, typically at or near-the-money, but you can also buy out-of-the-money options too. However, I like strangles better right now because premium has increased given the volatility we’ve seen and they are generally more affordable. You can apply these strategies to any market that’s volatile, but it bodes well for equities right now because we’ve seen some really explosive sell-offs as well as rallies.

Ratio Spread

Another strategy you can use to get some market exposure and keep your investment costs limited is a ratio spread, which involves an unequal number of long and short positions. It’s not appropriate for all markets and carries unique risks, so I recommend you work with a professional if you are not familiar with this approach. A ratio spread can be appropriate for markets that you feel will make a small move, but perhaps not an explosive one. I’ll use silver as an example.

I’m mildly bullish silver, and I believe the March contract looks to be showing a bottom around $9 an ounce. Volume and open interest have been increasing and the market has been breaking out as the U.S. dollar has weakened a bit. March silver futures moved above the eight-day moving average and up to the 21-day moving average just before the Thanksgiving holiday, which is technically bullish. For a ratio spread in this market, I would buy one March call, and then sell three against it. I would buy, for example, a $12 call and then sell three $15 calls, creating a one-by-three ratio spread. With this example, you want the market to move above $12, but don’t think it will move past $15. The price we pay on the $12 call is about 80 cents, or $4,000, not including your commission costs. The three calls sold against it would net about 33 cents for each, or 99 cents. So you collect a gross 19 cents, or about $950. These cost figures can change, so please call me for specifics if you are interested in a strategy like this one. With this approach, you are looking for silver to continue to move up to about $15 an ounce, but if silver stays under $12 or moves lower, you still end up at expiration with a net credit. Your maximum profit potential would be $15,000, and your breakeven is when silver is priced at $16.50 at expiration. Again, these figures are used as examples, and may change.

Keep in mind, if silver rises above $15, your written calls start to lose value. As you are naked two $15 calls, you can face unlimited risk if the market moves dramatically against you. However, this type of strategy can be viable for markets you think are getting ready to make a small move and allow you to collect some premium if the market doesn’t move quite as much as you expect.

There is a lot of fear out there, but you don’t need to let volatility scare you. Try to take advantage of it, because volatility creates opportunity. Always make sure you use good risk management when you trade, and work with a professional to find the best strategy for your particular account size and risk tolerance. Options can be complex.

Michael Sabo is a Senior Market Strategist at Lind-Plus, Lind-Waldock’s broker-assisted division. He can be reached at 800-798-7671, or via email at msabo@lind-waldock.com.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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