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How I Trade “Market Drops”.

Posted by Pete Stolcers on May 24, 2006

In today’s option trading blog, I will look at this sell off and the likelihood of a tradable bounce. I believe this 5% drop in a handful of days is the result of speculative buyers getting shaken out of the market. The fundamentals are still intact and the drop in my opinion is not justified. Considering my stance, I need to form a game plan and position myself in front of this freight train. Experience tells me that the more violent the drop, the more violent the bounce.

As the market drops, the implied volatilities (IV’s) of the options go up dramatically. In this case the VIX has increased 50% from 12 to 18. Uncertainly has entered the market and traders do not know if there will be continued weakness or a big bounce. The bid/ask spreads often widen in wild trading so buying options is not an optimal approach.

During the sell off I try to identify pockets of strength and I identify stocks that are holding up well. These normally tend to be the stocks that lead the market higher, have great earnings and reasonable P/E ratios. At some point all stocks will join the sell off and the baby will get thrown out with the bath water. These strong stocks will only participate to an extent until the buyers step up and support the stock. While the market is still searching for support, these stocks will hold up well. As soon as the market stops going down, they will show strength. On any rally, they are leading the way. I form a list of stocks that are displaying this behavior.

Next I identify where I think the market will find support. I formulate a few scenarios and try to estimate which support levels will be tested by the stock if the worst case scenario unfolds for the market. Then I start to evaluate the put premiums (IV’s) and the bid/ask spreads. If the market is approaching major support and it looks like support is forming, I will start scaling in to a variety of put selling positions. They vary from front month credit spreads to selling naked out of the money premium on stocks I want to buy. Eventually, a “full boat” will comprise 20% of my speculative risk capital. I will cover how I select the strategy I use in the next article.

These positions need to be established over time. I will never pick the bottom so I have to scale in. The wide bid/ask spreads force me a to work the order over time to get a decent fill. Eventually, when the bounce happens, it will be fast and furious and you will either be in or out. Trying to put positions on during a snap back rally is almost impossible.

This leads me to the next phase of the game plan. When the market has found support and the bounce is under way, I do not trade options. The bid/ask spreads are too wide and the IV’s will drop as the market rallies. I’m fighting two forces and I am leaving too much on the table. I trade the stock. The spread is much tighter and the liquidity lets me get in and out with ease. In the mean time (if I’m right) the puts I’m short get crushed in a matter of hours.

The key is that you have do your homework and be willing to take some heat. If you over leverage, you will lose. This is a great time to start finding those stocks.

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Option Trading Comments

  • On 05/24, Matt B. said:

    Great strategy.  I’m sure you’re running stock screens on the commodoties and see which ones haven’t fallen off the ledge yet.  TIE seems to bounce back with buyers faster than some of the others (ATI, CLF look toasted).  Would love to see what you turn up.

  • On 05/24, Matt B. said:

    Great strategy.  I’m sure you’re running stock screens on the commodoties and see which ones haven’t fallen off the ledge yet.  TIE seems to bounce back with buyers faster than some of the others (ATI, CLF look toasted).  Would love to see what you turn up.

  • On 06/10, Tom said:

    It has been about 2 weeks since this article and still there has not been a significant bounce in the overall market. Granted there have been some fairly good reversals in some of the stronger/higher priced issues but if one was not looking to sell within a day or two...any profits started to quickly vanish. Pete says based on experience the sharper the fall the stronger the rebound.  That is what we have seen many times, however this time it appears a bit different.  For the last two weeks many gurus have given many different reasons for expecting a strong rebound. It makes me think we are in for more selling when so many expect a sharp spike back up.  The point i want to make is that the market has a way of "conditioning" traders to expect certain things to happen based on previous events and the expectation that things will keep happening the same way.  As i see it, the only way to survive is have a plan to deal with the unexpected....because this time it just might be different.

  • On 12/09, ROBERT RANDOLPH said:

    Hi, thanks for all the great information. I have been having success selling calls that trade higher and then buy them back, usually the same day, when they are lower. How can I find stocks that have a large bid,ask spread?
    Thank you

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