Unless one has been hiding away for the past weeks most market followers are aware that stocks are in full-fledged correction mode given a decline of almost 17 percent in 13 days. The growing belief that the U.S. economy may be headed toward recession gave the stock market its fourth straight week of losses. The historic swings in the U.S. stock market over the past two weeks have investors struggling to figure out if we are near a bottom. The one thing that does seem clear is that volatility is far from over as the CBOE Volatility Index, also known as the VIX, is up 20 percent this week spiking up to 38% this past Thursday. Probably by now most of us have read the various market analyses and you can take your pick from among the many bearish signs out there: the spike in the VIX, and the stock charts confirming numerous bear market indicators including a major head-and-shoulders neckline break; the Dow Theory bear market signal - when both the Dow-Jones Industrial Average and the Dow-Jones Transportation Average closed below their closing price lows of June, 2011; bearish distribution days of massive downside volume accompanied by enormous negative breadth, and the crossing of the shorter term moving averages down through the longer term (so-called death cross), etc.
Where are all the bulls when you need them? The swiftness of this correction is unusual, but a 10% drop is not. Just last summer stocks fell 17% on issues similar to those we face today. If you're an investor who can't sleep tonight, sell until you can sleep. It is extremely difficult to make good financial decisions scared or tired. More to the point, other recent big sell-offs were among the worst times to sell. The Standard & Poor's recent slide is the longest since an eight-day drubbing ended on Oct. 10, 2008 when stocks rocketed 11.6% in the next session. Analyst have noted that the S&P 500 is 10 percent below its 50-day moving average and the most oversold the market has been" since March 2009. Also worth noting is that many individual investors are finally throwing in the towel. They were already nervous as it has been reported that they withdrew $23.5 billion from domestic equity funds during the week ended Aug. 10, more than in any single entire month since October 2008. On Thursday, trading volume at discount broker Scottrade Inc. was 77% higher than the day before and 50% higher than average of the four previous days, while TD Ameritrade also said volume surged.
But, now might be a good time to trade â€“ or more specifically, to sell option premium? The basic premise is that high volatility equates to higher option prices as traders demand a premium to take on the perceived risk. The concept is the opposite of taking a long position when ideally you buy options at a low premium and hope that volatility increases and you generate a profit. As a seller, you want inflated premium so that you can sell at higher prices and gain when the price pulls back. Despite the recent carnage, stocks still only trend up, down, or flat (recently is it just seems like downward is the only way they can go). But obviously, there is a risk element associated with betting on where the market will be given the time horizon you are looking at. As mentioned above, stocks are grossly oversold, bearishness permeates investor psychology, retail investors have bailed out, and there is not a bull to be found in the house. We need to emphasize that we are absolutely NOT trying to suggest a market bottom, which is a fool's errand without a doubt.
Stepping back a bit from the madness and emotion there is a strong case to be made for now being a good time to sell option premium, as we have to ask ourselves, how much downside risk is left â€“ at least in the near term? Making a long directional near-term trade would have to be considered speculative at this point, especially to the upside. On those days when stock prices try to recover, traders quickly step in to sell during rallies â€“ going long appears to be really a long shot right now. We currently can generate high premiums from selling options, plus the high volatility has expanded the range for getting a good trade â€“ the point is that depending on your trading plan, now might not be a bad time to trade? Keep in mind that three-quarters of companies in the S&P 500 to report earnings have posted record earnings and better-than-expected 17.9% profit growth, says S&P. Such solid profit provides a reminder that despite its troubles, the U.S. economy is still probably the best place in the world to invest.
DIA Position Update ---------------------------------------------------------------
DIA closed at $107.91 on Friday
DIA is priced BELOW its current 14-day EMA (see DIA chart down below)
DIA is trading BELOW its 20-day Bollinger Band SMA (see DIA chart down below)
DIA is BELOW its 50-day simple moving average (see DIA chart)
DIA is BELOW its 200-day simple moving average (see DIA chart)
Relative Strength Indicator (RSI) is bearish (See DIA chart)
Moving Average Convergence/Divergence (MACD) is bearish (See DIA chart)
The August 18th Couch Potato published a September expiration month DIA bull put spread (see tables below)
DIA Risk Analysis
We have not yet opened a September call spread, therefore the only risk is that stock prices continue downward and threaten the $100.75 short put strike price.
As with initiating the trade, the decision process for exiting our DIA bull put spread position will be simple:
Anytime the market maker is willing to accept a limit price of less than .11 on one of our short strikes, buy back all the short contracts and sell the long positions on the same spread. However, if it is a few days prior to the expiration date, we may be able to hold out for a .05 bid.
If one of our short strikes is penetrated (closing price below the short put) AND the delta rises to .65 we will look to close out this spread (buy the short contracts, sell the long) and roll it out to another short strike price. Unless this is option expiration week, do not panic and rush to close the trade, many times the market will reverse itself and remove the sense of urgency. If one of our short strikes has been violated and there is no price reversal, we cut our losses and live to fight another day.
As mentioned above, the fact is that now might be the optimum time for selling options. Last month Couch Potato trade results are a good example. August options started the month with prices floating toward recent highs and low volatility. Then, after the U.S. debt ceiling negotiation fiasco hit, the market began its current correction with the accompanying high volatility. Our August iron condors were in play prior to the price pullback and the bullish positions suddenly where deep in the hole. However, we caught a break as after stocks initially crashed, prices somewhat bottomed out a bit a few weeks before August option expiration. This gave us an opportunity to execute the necessary trade adjustments and sell at higher prices. The surge in implied volatility after the August trades were in play obviously hurt, but volatility remained high and we were able to significantly reduce the potential loss.
No doubt there is fear and a little panic currently going on in the stock market. But that should not in itself be a reason to worry as the great thing is the market makes the necessary adjustments and inputs a risk premium in option prices. For example, note in the chart above the increased spread between the upper and lower Bollinger bands. And we have already been discussing how expensive options have become due to elevated volatility. We have discussed this in the past; our logic should be similar to how insurance companies operate. During times of increased risk, insurers continue to write new business, but they are more selective about the risk they take on and they demand a higher premium â€“ we can follow the same strategy.
Couch Potato Trader Disclaimer
All results reported in this section are hypothetical. While the numbers represented here may have been achieved or beaten by our readers, we make no representation that any individual investor achieved these exact results. The tracking for the plays listed in this section uses closing prices for the day the newsletter is published and it is not meant to imply that any reader actually received those prices (though many often do) or participated in these recommendations (even though many do). The portfolio represented here is hypothetical and for investment education purposes only. It is only an illustration of what type of gains a knowledgeable trader might receive utilizing these strategies. If you don't get close to these results, guess what. It isn't the fault of the strategies.