Thursday, June 07, 2012, the SPX pushed up to 1329.05 and then tumbled more than 16 points into the close. Imagine that you thought that the SPX was topping out. You thought it likely that the SPX could roll down to the bottom of a regression channel in which it had been trendling lower. If you were wrong, however, and the SPX made it past about 1340, it might zoom all the way up toward 1392.
SPX on June 7:
What is the best trade to try to capitalize on your view that the SPX could head to the bottom of that channel again? Of course, we know what actually happened over the next week, but the trader looking at that trade on June 7 didn't have that bonus.
Before we decide, we need to look at what the VIX, the volatility index for the SPX, is doing.
VIX on June 7:
On June 7, the VIX is in the lower half of its range over the last two years. While the VIX is not the same as implied volatilities, it serves as a good approximation when we're looking at the SPX. Since lower implied volatilities suggest that options are relatively cheap, and higher implied volatilities suggest that options are relatively expensive, you'd like for implied volatilities to be in the lower third or so of their typical range when you buy long options.
In this case, the VIX is near the middle of its year-long range. It's not giving you a lot of clues as to whether options are cheap or expensive. It's possible to go deeper into the study of the skew of the individual options to determine which are cheaper and which, more expensive. Let's keep this simple for the sake of this discussion and also because I'd probably mess up that discussion.
Before you decided on the most appropriate options trade, you'd also need to factor in how much you wanted to devote to the trade and how certain you were of direction. If volatilities were lower, your decision might be easier. Long options would be cheap enough that a long put trade might be most appropriate if you wanted a directional trade.
Suppose you decide to chance buying a long put even if conditions aren't optimal. Your choices are to buy an out-of-the-money, an at-the-money, or an in-the-money option. You can choose a soon-to-expire weekly option, a soon-to-expire monthly June-expiration one, or a further out option. You'll read in other places about the pros and cons of each of these choices. Here, we're just going to look at some prices and compare them with actual results. Let's choose July expiration and look at expiration profit-and-loss charts for an ATM, ITM, and OTM put.
Note: I will not be including commissions in this discussion, and prices will be mid-price or mark. If we were considering implementing a trade strategy and testing it, this would not be a valid way to back test a trading strategy. Not only would commissions need to be included, but also we would need to devise some way of accounting for slippage. That usually means buying at some number or percentage above the mid and selling at some number or percentage below the mid. We're just taking a quick overview here, so our goals are different.
At the money: JUL 1315 Put: $35.45
70-delta ITM put: JUL 1360 Put: $58.55
OTM put: JUL 1260 Put: $18.65
The costs of the puts on June 7 when this article was roughed out are included in the header for each PnL chart. Perhaps you didn't want to devote that much money to a trade. You wanted less margin and less risk and were willing to accept a smaller gain. You could choose a put debit spread.
JUL -1310/+1320 Put Debit Spread:
Theoretically, the cost of this spread would be $400. The possible profit would be $600.
You could try a call credit spread with a similar expiration PnL chart.
JUL -1310/+1320 Call Credit Spread:
The credit you take in is theoretically $586.00. Your risk is theoretically $414.00.
What if you're not so sure about the direction? Markets are risky, and the SPX could as easily shoot higher if your supposition is wrong and SPX prices get past next resistance.
You could try a neutral butterfly. You decide to put it on ATM, so you choose an iron butterfly, using both puts and calls.
JUL +1370 call/-1315 call/-1315 put/+1260 call Iron Butterfly:
This trade delivers a $4190 credit. It has a potential maximum profit potential of $4190 and a maximum loss of $1310. Although you'd have to have the luck of a lottery winner to ever collect that maximum profit, traders have found it remarkably easier to end up with the maximum loss!
Let's take a look at these next week and talk about which fared best over the course of the ensuing week.