Strategies for Uncertain Markets and Uncertain Times

November 21, 2008

Name: Steve Salman

Company: Option Investments, Inc.

Years Trading: 15

Favorite Movie: Holywood Knights

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We are in a time of complete economic turmoil. Everyday, traders wake up with little to no clue of what the market may do that day. Earlier this month, the Dow Jones Industrial Average was averaging a loss of 436.5 points a day. At that rate, the DJIA was on track to be at ZERO in 19.6 trading days. Ironically, if someone claimed the market could move 400 points day after day in such a short period of time, people would have laughed and said they were an extremist. Today, the market moves 400 points and people accept it as par for the course. Many of the technical indicators that traders have built their entire trading systems on have become completely unreliable. There is an old expression that says if America sneezes; the rest of the world catches the cold. If you hold this expression to be true, then beware and be prepared to hold on.

The days when the Volatility Index (VIX) would trade around 40 and considered to be extremely high, may be over for now. The last few weeks worth of trading has pushed the VIX to new all time highs, well above 60. It is understood in the trading community that volatility equals risk. The higher the volatility, the more likely the market will make a large movement, thus exposing traders to more risk. The idea or goal of a trader is to predict, during times of heightened volatility, which direction the market will move and capitalize on it. Obviously this is easier said then done. As times become even more trying for investors and traders, the question of ‘what are traders supposed do during these unpredictable and challenging times,’ becomes echoed among the industry. Some of the industry, just as well, feels that sitting on the sidelines is the best play. However, others feel that even though the markets are irrational, there must be a way to capitalize on them.

If you belong to the ‘others’ and feel there has to be a way to take advantage of this heighten fear and risk, but don’t know how, then read on.

Options traders, if positioned correctly, have the opportunity to profit during these challenging times. Unlike traditional investments, options allow a trade to profit in three different types of markets; Bull, Bear, and Sideways markets. When options traders are submersed in market conditions like the ones we have seen recently, they immediately ask themselves which strategies will work the best based on the current varibles. The variables to consider in today’s marketplace are: Heighten volatility with an expectation that volatility will continue to be high for several more week or go higher, markets may move strong in one direction or another, and/or a market appears to be on verge of a major movement based of off current support or resistance levels. Based on these assumptions, put and call option credit spreads maybe just right for a particular options trader. It should be stated that futures and Options involve a high degree of risk and are not suitable for everyone.

Put and call spreads are simple techniques for selling a put or call with a protective long option to define risk. These are often done with the short side of the position at- or near-the-money during a period of medium to high volatility where as the traders bias is in the opposite direction of the option sold. Selling a 900 call and buying a 950 call would be an example of a call credit spread, while selling an 800 put and buying a 750 put would be an example of a put credit spread.

Put and call credit spreads are less a practice of time decay modeling and more a matter of directional bias and volatility. It is best to utilize this approach when alternative premium collection strategies seem less attractive given the pricing model in the market and timing elements of the trade. While this strategy can be legged into, it should be acknowledged that if you sell naked premium with the intent of buying the protection (long) at a later time, the risk, margin, Return on Margin (ROM) and emotion of the trade are all compromised.

Selling put and call credit spreads offers traders an excellent way of taking a directional market view while simultaneously implementing a strategy (if done properly) that takes advantage of a given pricing structure in an option market that over prices the short option and discounts the long option in the trade design. It offers defined risk, potentially beneficial ROM, the possibility of quick premium collection (because of the directional bias of the trade) and the ability to make adjustments throughout the trade.

Enter these spreads for one or more of the following reasons:

1) You have a strong directional bias and the market is offering a good premium structure in the option chain (overpriced short, discounted long premium)
2) The short option strike price is above resistance (for calls) or below support (for puts)
3) Choppy and volatile trade is anticipated with the intent of covering the short after some premium collection is achieved and holding the long for additional gains
4) A short term move is expected in the opposite direction but a long term trend is likely in the direction of the trade (cover the short on the initial move and hold the long for the trend play)

Target spreads with a maximum risk to credit received ratio of better than 6 to 1. Look for spreads that offer 25% or more ROM and 120% or more annualized ROM. While the time aspect of the trade is less relevant than with other types of premium collection trade designs, it is recommended that you target trades with 4 months or less until expiration.

I hope this strategy helps you navigate through these unpredictable market conditions. Remember that options and futures involve a high degree of risk and are not suitable for everyone. If you are unsure of these strategies or how options work, then do not invest your hard earned capital into the markets until you are comfortable and can afford the risk. These market conditions are not for the faint of heart. Knowledge is power and as trader you should continuously commit your self to education, and one of best educations a trader can receive is the hands on experienced gained trading during both the best and worst times of a market. Good luck and good trading!

About the Author

Steve Salman was born in Montreal, Canada and raised in beautiful southern California. Growing up he watched his father buy lumber for the family furniture business. By 18 years of age, Steve knew the spot prices for Mahogany, Walnut, and Oak. Naturally this led him to his life passion for trading.

Today Mr. Salman is a registered CTA for Avalon Capital Advisors and a branch manager for OpVest. He has been trading for over 15 years and has done everything from being a currency specialist, bond trader, to an options educator. With today’s market conditions, Steve believes diversification and proper money management are required to be a successful trader. Steve currently holds a series 3 and 30 along with being a registered CTA.

Ssalman@opvest.com