Option Investor
Educational Article

Let's Do The Limbo Rock!

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By Lynda Schuepp

Trading in this market reminds me of the lyrics of an old limbo song, "How low can you go?" Friday saw the Nasdaq slip or should I say fall another 5% to lows not seen since December of 1998. How much bleeding before we say uncle? The famous contrarian indicator, the put/call volume ratio closed at .81, not near the extreme levels needed for capitulation. Now that should be the word of the year. I'm sick of hearing it on CNBC. The dictionary defines capitulation as the act of surrendering or giving up. Guess what guys, it doesn't look like we're there yet. The charts are ugly in any time frame. As an option player, it's risky to play it directionally. There are no signals to go long, but it's scary going short or playing to the downside, because it's hard to believe we could go any lower.

There are three options (excuse the pun) in my book: take a winter vacation, trade intraday or play it safe using spreads or long-term plays. Let's look at the pros and cons of each.

The first option would be to take a winter vacation. Bull markets are much longer than bear markets, so even if you go away and the market turns, you won't miss the majority of the action. What you might miss is a bear rally. Remember the market took a lot of prisoners on the way down who are looking to "break-even" at this point, so there is tons of overhead resistance to get through on the way back up. Based on the weather we've been having in Boston this winter, vacation to a warmer climate is sounding better each day.

The second option is to micro trade, taking small bites intraday. No homeruns in this market, just singles. The secret to day trading options is to find those stocks that have lots of volume with options that have small bid/ask spreads. It's hard to trade the once "high-flyers" because you can lose too much just getting in and out, which is called slippage. You might think an option selling at a bid of $2 and an ask of $2.50 is pretty reasonable until you realize that a 1/2 point on $2 is 25%. Multiply that by 2 to account for buying and selling same day and the option has to rise 50% just for you to break even. This is where a lot of option traders make their mistakes. The easiest options to day trade are the QQQ's and the OEX, using the current month "at-the- money" strikes. There are two reasons that make these a good choice. First, you can't get entirely nailed on bad news because they are both made up of 100 stocks, and secondly there is plenty of open interest and volume trading, so the spreads stay fairly tight and somebody is always willing to buy or sell to you, unlike some stocks that only trade 40 or 50 contracts a day.

Looking at the QQQ's, Friday's action saw them run from $47 down to a low of $42 and back up to close at $45. The 45 strike on the QQQ's showed volume of 6390 contracts on the calls and 11,350 contracts on puts. Now that gives me some hope. The number of puts to calls was 2 to 1 which is very pessimistic. That's good news. The more bearish, the more likely we are near the end of the limbo rock, after all, we can't go any lower than the ground. The OEX isn't as pessimistic. It traded about 1400 call contracts versus 1900 put contracts. Therein lies some of the problem with the put/call indicator which uses all equities plus index options. Fund managers use OEX options to hedge their portfolios, so I personally don't think the old ratio is quite as useful as it used to be. This disparity suggests to me that the Nasdaq may be really close to a bottom, but the OEX isn't quite there yet.

The third option would be to do some longer-term plays, the "Rip Van Winkle" approach. I think everyone should get into some of this action. Because the QQQ's closed at $45, I would first look at the strikes of 40, 45 and 50 because they are "at-the-money." At-the-money strikes have the most liquidity and the smallest spreads. Next, I'd look at bull calls spreads (buying a lower price strike and selling a higher price strike). And lastly, I'd look at the prices looking at near months (April, June) and long-term (January). It is interesting when you look at the same strikes with various months, you will see that the farther months are more fairly priced, because implied volatility is lower. The cost for a 40-45 call spread (long QQQ'S 40 strike and short QQQ'S 45 strike) would cost $3.10 per contract using April and cost $2.90 per June contract and only $2.30 per January contract. The most money you can make on a debit call spread like this is the difference in the strikes less the cost of the spread. The January spread could yield $2.70 (45 short strike less the 40 long strike less $2.30 cost of the spread). The same spread using April's prices would yield a maximum of $1.90 per contract. Looking at these two scenarios, which do you think is less risky? Risk $3.10 to make a maximum of $1.90 and only have until April to be right or risk $2.30 to make a maximum of $2.70 and have until January to be right.

These are the steps you must go through when trading options. Take the time and do the work and get the whole picture. Look before you leap (no pun intended).


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