Option Investor
Educational Article

Gearing Up For MOCO

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In yet another example of Newton's Law of action-reaction, it seemed as though my Monday article fell into the realm of self-fulfilling prophecies. Bad things happen in bear markets and the WCOM announcement yesterday is a perfect example. Investors aren't so concerned with the meltdown of the company, but they are very worried about where the next cockroach is going to come from. Very rarely do you only find one or two. Recall that I was looking at historical pattern of the VIX with respect to broad market action. I got a wave of positive email on that article, so it seems that I hit on a useful way to describe the mechanics of the VIX moving to extremes.

If you missed that article, you can find it Here.

Yesterday, I thought of another analogy that applies to the setup I'm looking for with respect to the VIX. What I want to see is a capitulative selloff that drives the VIX over 40 (preferably above 50) in response to the major indices plunging below significant levels of support. Remember when you were younger and set up hundreds of dominos in a pattern, so that when you pushed the first one over they all fell down in order? I clearly remember one such childhood experience, where the final domino that tipped over fell into a glass of water.

Equating the process of knocking down dominos to getting the capitulation that I'm looking for, WCOM's admission of fraudulent accounting was the equivalent of pushing over the first domino. If everything plays out the way I would like (wouldn't that be nice!) the VIX spiking above 55 is the equivalent of that last domino falling into the glass of water.

I received a number of emails today, asking if I thought this was the capitulation day that would put a bottom in place and let me institute my MOCO trade. In a word, "NO". Don't get me wrong, there was the possibility for a washout session when the DOW was trading down by 180-200 points and the VIX was inching up to the 36 level. But the Buy Program in the final hour that sent all the indices back near breakeven on the day caused the VIX to collapse back to just above 32. As Art Cashin said on CNBC this afternoon, floor traders didn't like the rebound off the lows, as there was no catalyst for the improvement. As he's been saying for weeks now, we need to get a washout, and today was clearly not it.

Oh sure, the rebounds off the lows both this morning and this afternoon were tradable events. But they don't fit within the parameters that I'm looking for in my MOCO setup. Today the rubber band got stretched the most it has been since the end of October, but there is still a lot more stretch left to go. My strategy will be to hold my fire until I see what looks like true panic, and we certainly didn't see that today.

It is important to highlight that I could very well be left at the altar if the markets fail to deliver the setup I'm looking for. I've defined my action points based on specific VIX levels, as I really don't care what the specific price levels of the broad market are at the time I start initiating my position. This is a VIX trade, pure and simple.

So let's talk about what I'm planning on trading and how I will implement the trade. Since I am planning on triggering my entries on specific VIX levels, it seems that I better define what those levels will be, and how much capital I will allocate at each of those levels. I've already decided how much money I will allocate to this trade and since we all have different risk profiles, we each need to decide what that dollar amount is. But I think it is valuable to show how I will allocate capital to the trade as the dominos fall.

Trigger           Action
VIX > 40          Invest 10%
VIX > 45          Invest 15%
VIX > 50          Invest 20%
VIX > 55          Invest 25%
VIX > 58          Invest 30%
Note that by the time the VIX reaches 58, I will have established the entire position value that I originally decided on. This may seem counter-intuitive, that I am only willing to establish a full position if the market reaches the level of panic last seen in September. Rational minds would rightly state that we shouldn't see that level of panic anytime soon. Those same people would have told me 2 months ago that there was no way that WCOM would be a bankruptcy candidate or that the S&P 500 would test its September lows. Well don't look now, but WCOM is headed for bankruptcy court (in my never-to-be humble opinion) and the intraday lows on the SPX today were a mere 8 points above the September intraday lows.

Let me state it another way. If the VIX only rises to 45 before the big recovery gets underway, then I will only have allocated 25% of my maximum amount to the trade. The higher the VIX goes, the greater the potential reward (rubber band stretched to the limit), and therefore, the greater the amount I am willing to risk. My reason for scaling into the trade is that I don't want to completely miss out if the VIX reverses from a level lower than my hoped-for 58-60 extreme. That is the reason why fully 55% of my investable amount for this trade is allocated in the VIX = 55-60 range, where potential reward is highest.

Now that we've finished setting the action points, we need to determine what we are going to take action on. We're looking to benefit from a broad market rebound and for me that means either one of the S&P indices or the DOW. I don't even consider the NASDAQ or the QQQ as viable for this trade. Until cap-ex spending sees some sort of meaningful growth, the QQQ will remain effectively dead in comparison to the DOW and S&Ps. After perusing historical option price charts, I could see that I would get better bang for the buck by trading the SPX or OEX contracts, but managing the allocation percentages I highlighted above is tough with less than $25-30K to work with. Due to the lower contract costs and my expectation that the DOW should lead to the upside on the snap-back rally that I'm expecting, I chose to go with the DJX options. Utilizing the September contracts should give me more than enough time to be right and that just leaves me with the issue of choosing what strike level to buy.

Well, that is a bit of a dilemna, now isn't it? Since we don't know where the DJX will be trading at the point of entry (and it will likely be at different levels for the different VIX readings), the solution to this problem is to define the targeted strikes as being a specified distance from ATM at the time of entry. I went through some historical option charts (DEC-01) for various strikes and found that from the bottom in September, with the DOW trading near 8000, the best bang for the buck (>600% Return) came from the DJX 90 Calls over a 2-month holding period. However the return from the DJX 86 Calls was still really solid at 500% over the same time period. Using a lower strike started to seriously impact performance due to the deleterious effect of the volatility and theta premium built into the At-the-money and Near-the-money options.

This is an important point, as we are looking to buy calls in a period of exceptionally high volatility. We will without a doubt be buying options with inflated premium due to that volatility. But the further we go OTM, the less impact that volatility will have on the cost of our options. So essentially, we are going out-of-the-money to minimize the volatility collapse that hits our contracts and we are using distant month contracts to minimize the effect of time decay.

After looking at what seemed to be an endless parade of options charts, I finally decided that the best balance of return for capital invested was likely to come from options 400-500 DOW points OTM at the time of purchase. So if the VIX hit 40 with the DOW at 8800, then I would be looking to buy the September DJX 92 Calls on the first hint of a serious rebound, allocating 10% of my capital earmarked for this trade. Then if the DOW continued to fall with the VIX still rising, I might get the VIX trigger of 45 with the DOW trading at 8600. Then I would allocate another 15% of my capital to the trade using September DJX 90 calls. I think you can work out the rest of the projections, based on the table above.

I've said it before, but it bears repeating that this sort of trade is not for the weak of heart. It is a HIGH RISK trade and there is likely to be a fair amount of volatility surrounding the capitulation bottom that we are trying to buy into. Likewise, it is not for impatient traders that don't have the ability to patiently sit on their hands, waiting for exactly the predefined setup before putting capital at risk. But it is the sort of trade that appeals to me for all the reasons that I laid out in Monday's article.

I may be totally wrong in waiting for the blowoff in the VIX to get me into the trade. If so, then I'll let this one go. I will not force the trade by changing the levels. A VIX of 38.50 is not "good enough" for me. That's why my action plan is written down in my trading journal. I have an action plan and that is how I'll stay alive and hopefully profit wildly in the volatile times ahead. You're more than welcome to tag along with me on this adventure or watch from the sidelines. Either approach will likely provide a valuable educational experience. As appropriate, I'll come back to this topic and we'll see how things are playing out.

Have a great week and beware of the bear!


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