Coping With Volatile Markets, and Using Options Strategies
By Matt Krupski ISSUE 608 | AUG 2007
Recent turmoil in financial and commodity futures markets has even caught the attention of people who don't regularly follow the financial pages. I've had countless people ask me recently: "What's going on in the markets?" I have some general rules for traders that are good to follow in any market, but even more so in these volatile times. And, I'll offer some options trading strategies to consider if you want to hedge or augment your portfolio, using examples in the S&P 500 futures.
Trading Rules
Maintain your discipline. In volatile times, it is especially easy to get emotional about trades. Seeing large swings can be wildly elating or hugely depressing to one's psyche. For this reason, before you even enter a trade, it is important to have a defined objective and risk tolerance, and make sound, reasoned decisions. It is easy to get caught up in watching the price swings and just try to jump on board, simply buying something that's going up quickly and selling something that's falling. However, if you have no discipline in why or how you are entering your trade, you can often get caught in a "whipsaw," selling low and buying high or vice versa.
Your reasoning can be either fundamental or technical in nature, but if you slow down and define why you will enter a position, it will help you to keep the emotions out of your trading. In addition to defining the reasons for entering a trade, it is good practice to consider "what-if" scenarios in planning your exit strategy. How much are you willing to risk on your trade (be it a percentage of the account or a specific dollar amount)? What are you going to do if the trade goes against you? Are you hedging with options? Are you using stops? What is your profit objective? If you evaluate these situations before entering the trade, it will help you to maintain your discipline and hopefully improve your performance. Even if you consider these rules prior to trading, it is easy to let your discipline fall by the wayside and ignore your exit strategy when you are making or losing a lot on a trade. If this is the case, consider working with a broker who can help act as your coach, forcing you to maintain your discipline.
Stay humble. I often hear people say a market "can't go any higher" or "can't go any lower," but I have to remind them that yes, it can. No one is bigger than the market. No matter how good a fundamental case you have, or how reliable a technical indicator has been in the past, the market can and will change, and it will do things that may seem to be irrational or incomprehensible. This is where discipline comes into play and humility can save you money. No matter how "right" your trade may be, you need to be able to withstand moves against you in order to capitalize on your idea. If you don't trade with discipline, you may find yourself forced out of a position due to margin issues, only to then watch the market turn around. Having the ability to say "I'm wrong" or at least "I'm early" and exit a position at a loss will help you survive to eventually catch the winning trade. Picking a bottom or catching a top is exceedingly difficult. The saying "the trend is your friend" is always a good adage to remember. If you insist on fighting a trend, trade smaller, reducing your exposure until you see signs that the trend is changing.
Stay flexible, and adjust for market conditions. I frequently hear from traders, "it will eventually be a winner, if I just hold it long enough." However, if you have this view, you have to consider the true cost of holding the position. The position may go against you for weeks, months, and even years at a time. You may have to send in money to maintain the position if you get a margin call. In the meantime, your stubbornness may be costing you more money because of the opportunity costs of your trade. When you are holding on to a losing trade, you may not have enough money to enter winning trades in other markets, costing you more than you may realize. Most traders agree one of the keys to trading is to cut your losses quickly and let your winning trades run. In these volatile times it can even more difficult to adhere to this rule. Adjust your trades accordingly.
The leverage that futures offer is attractive, but the leverage cuts both ways. When prices are swinging wildly, it makes sense to cut back your size. Large moves can lead to quick margin calls and force you out of good positions. In cutting back your size, you are able to withstand some of the volatility and allow your trades to work for you. Similarly, even if you abhor stops or hate buying option premium, these tools can be exceedingly useful in volatile times to reduce risk, hedge yourself and allow you to hold your core positions.
I have frequently mentioned the importance of hedging yourself, or using options to gain exposure to these markets in volatile times. Options provide a great tool to augment your position. In general, as volatility increases, the cost of options increase. Now I'll cover some simple strategies that you can consider in volatile times like this.
Options Strategies
Covered calls/covered puts. If you have a futures position, one strategy you can use is writing (selling) calls against a long position, or writing puts against a short position. Let's look at a hypothetical example. You decide to buy one September S&P futures contract at 1424.50 on the close of the day on August 16. If, at the same time, you sold one September 1500 call, you would collect about 12.50 points. In selling the call, you are giving someone else the right to buy the September future from you at 1500. The only time they would exercise this right is if the future is above 1500, so you are capping your profit at 75.5 points on the future (1500-1424.5). If the market is below 1500 at expiration (the September S&P futures and options expire on the same day: 9/21/07), the calls go out worthless. In either case, you keep the 12.50 points. If the futures decline, the value of the calls should diminish, and you can buy them back at a profit, thus partially offsetting any losses you take on the future.
Similarly, if you sold one futures contact on August 16 while simultaneously selling a September 1350 put, you would collect around 25.50 points. You are giving someone else the right to sell you a September future at 1350. The only time they would do this is if the future was below 1350. So, you are capping your profit at 74.5 points on the future (1424.5-1350). If the market is above 1350 at expiration, the puts go out worthless. In either case, you keep the 25.5 points. If futures go up, the value of the puts should diminish. You can buy them back at a profit, thus partially offsetting any losses you take on the future.
Vertical spreads. In volatile times, people often want to clearly define their risk prior to entering trades. Buying call spreads and put spreads is one way to do this. Buying a call spread involves buying one call and selling another call against it with a higher strike price. In doing so, you are capping your profit potential but decreasing the total cost to enter the trade. For example, the September S&P 1425 calls closed at 47 points on August 16, 2007. If you bought one of these while simultaneously selling the 1500 call at 12.5 points, you decrease the total cost of the trade to 34.5 points. In buying the 1425 call, you have the right (but not the obligation) to buy one S&P future at 1425.
In selling the 1500 call, you have given someone else the right to buy one S&P future at 1500. If the market is below 1425 at expiration, both calls will expire worthless. If the market is between 1425 and 1500, the 1500 call will expire worthless and you will be long one future from 1425 if you exercise your call rather than exit the position. If the market is above 1500, both options would be exercised, and you would buy one future at 1425 and sell it at 1500. In this case, you have lowered the cost of the trade by about 26 percent (from 47 to buy the 1425 call outright to 34.5 for the spread). Your maximum risk (assuming you do not "leg out' of either side of the spread) is what you paid for the spread, plus commissions and fees. In exchange for the lower cost, you are capping the maximum profit potential to 40.5 points (the 75 point differential between strikes less the net cost of the spread). In addition, you could offset the spread at any time between now and expiration.
If you thought the S&P index was going to decline, you could have bought the September 1425 puts at 47 points on August 16. To offset some of this cost, you could have sold the September 1350 puts and collected 25.5 points. In buying the September 1425 puts, you own the right (but not the obligation) to sell one September future at 1425. In selling the 1350 put, you are giving someone else the right to sell you the future at 1350. If futures are above 1425 at expiration, both options expire worthless. If futures are between 1350 and 1425 at expiration, you would exercise your 1425 put and be short one future from 1425, and the 1350 put would expire worthless. If futures are below 1350 at expiration, both options would be exercised. You would sell one future at 1425 and buy it back at 1350. In this case, you have lowered the cost of the trade by about 53 percent (from 47 to buy the 1425 put outright to a cost of 21.5 for the spread). Your maximum risk (assuming you do not "leg out' of either side of the spread) is what you paid for the spread, plus commissions and fees. In exchange for the lower cost, you are capping the maximum profit potential to 53.5 points (the 75 point differential between the strikes less the 21.5 net points paid for the spread). In addition, you could offset the spread at any time between now and expiration.
These are just a few ideas with one market example. Feel free to contact me to discuss other ways to cope with changing market conditions, and to tailor a strategy unique to your particular situation.
Matt Krupski is a Senior Market Strategist with Lind Plus. You can contact him at 877-847-3034 or via email at mkrupski@lind-waldock.com if you have questions on this topic or to discuss specific trading strategies for your unique situation.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email 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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