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Market Bounce Coming - Here’s How To Play It Using Options

Posted by Pete Stolcers on October 11

Posted 9:30 AM ET – Yesterday we saw the heaviest day of selling since February. Rising interest rates and a likely trade war with China sparked profit-taking. Once the momentum was established, trading programs kicked in and we were in a freefall. We got the pullback we’ve been waiting for and we are in cash. Get ready to buy.

There are many positives that will attract buyers. Domestic economic growth is extremely strong, inflation is moderate, trade deals with Canada/Mexico will be signed, earnings season will produce record profits and seasonal strength will begin.

Today I want to give you a lesson on option buying when the market tanks. The temptation is to buy the bounce. This is fine if you are buying stock or futures, but these trades need to be short term in nature. Bottoms take time to form and a retest is likely.

It is not wise to buy calls on the first bounce. Option premiums are extremely expensive. During the first bounce you will be on the right side of the move and you won’t make any money. Option implied volatilities will collapse and you will be fighting that headwind. Furthermore, a retest of the low is likely and you could find yourself on the wrong side of the trade. The bottoming process takes time and he will also be exposed to time decay.

In the chart you can see the VXX (it measures how expensive/cheap option premiums are). Market declines are caused by uncertainty and option premiums rise. When the market rallies some of the uncertainty has been resolved and option premiums decline. This is all due to option implied volatilities.

In the chart you can see that the first drop was dramatic and there were a series of bounces. All of these were head fakes and the base took a long time to form. Buying calls during this stretch would have been a losing proposition. Even buying calls on the breakout in May lost money. Option implied volatilities were lower, but the market was trapped in a tight range and time decay whittled the way at the premium.

The next dip in the chart happened in June. You can see the spike in the VXX. In this instance the temptation would’ve been to buy the bounce off of the 100-day MA. Option premiums are expensive and the market retested that support level. Just waiting a few days would have saved you a lot of money and you can see how quickly the VXX dropped. If you bought the first bounce he would’ve also had downside risk exposure because the SPY could have broken support.

There is an old adage, “the second mouse gets the cheese”. Call buyers need to have this mentality.

Option traders who want to play the bounce should focus on selling put premium. You will benefit from a collapse in option implied volatilities and time decay will also work in your favor as the base forms.

In my comments I simply outline when to buy/sell the SPY. If you are following my instructions and trading options, you should save this lesson. If option implied volatilities are high, favor put selling. When option but volatilities are low you can favor call buying.

We are in a very long-term bullish market and I will be buying this dip. Swing traders did not buy the SPY yesterday. Once $281.50 was breached we never traded above $282. Buy the SPY if it trades above $282. Use $281 as a stop on an intraday basis. We will also have a second order working. If the SPY trades down to $275, buy it when it crosses above $276. Option traders should be favoring put selling strategies (bullish put spreads).

This base could take a week or two to form, but good earnings will attract buyers.

Day traders should be patient on the open. I don’t believe the market will move higher until the downside is tested. That probe could be very short-lived and ideally we will test $276 and we get a snapback rally. That would be a sign that the lows are in and that you can aggressively trade from the long side today. We are just above the 200-day MA and I’m expecting to see support.
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