by Russ Allen, Online Trading Academy Instructor
Online Trading Academy Article of the Week
You can use put and call options in several different modes, depending on your market outlook. You can use an option trade that will make money from a rising market, if that is what you expect. If you think the market will be flat, you can choose a strategy that will profit from a lack of movement in either direction. And, if you think a down market is coming, you can take a trade that will make money if that happens.
If you are bearish, of course there are various non-option strategies that could be used to profit from a market drop:
You could sell short individual stocks, or exchange-traded funds (ETFs) that represent stocks. If the market drop did materialize, you could then close out those trades at a profit by buying back the short position at a lower price.
For more leverage, you could sell futures contracts on the stock indexes instead of stocks or ETFs. The futures contracts, being leveraged at 20 to 1 or more, will show a much bigger profit if the drop does occur.
You could buy inverse ETFs which go up in price when the market goes down.
Those are powerful strategies and often one of them will be the best choice, but buying put options is another simple bearish alternative with some unique properties. When done properly, and at the right time, this can pay off very well.
Below is a weekly chart of SPY, the ETF that tracks the S&P 500 index as of April 27, 2016.
Notice that SPY was approaching the highs near $215 that it first made in June of 2015 and retested in November-December 2015. Could the third time be the charm? Or would SPY drop 15% from here as it had the last two times?
The participants in the options market were not expecting a big drop. We know this because options were going for very cheap prices. The indicator at the bottom of the chart shows a measure of the relative expensiveness of options. It was extremely low. This indicates that people who were selling and buying options did not believe that there would be much price movement in the near future. The market was very complacent, which is usually the case before a meltdown.
There is of course the chance that their complacency could be well-founded. Maybe nothing bad will ever happen again.
If you weren’t so sure about that, you could use options to make a trade pretty cheaply that would profit from a big drop in price. And in this situation of extremely cheap options, it could be better than the bearish alternatives mentioned above.
The $200 strike August puts, for example, were available for about $475 per contract. This bearish trade would pay off in a big way if SPY dropped hard. And:
Unlike a short stock, short ETF position or short futures position, the option position’s loss would be strictly limited in case the market went the “wrong” way (up). The very maximum loss per option contract would be the $475 paid, even if the market should skyrocket over a weekend where stops in the other markets would not be effective.
Compared to an inverse ETF position or a short ETF position, the option could be bought for very little money out of pocket – $475 per 100 shares vs. more than $20,000 per hundred shares for the ETFs.
Options were coming from a situation where they are unloved and cheap. In a hard and fast crash, the sudden demand for the put options by those scrambling to buy them as insurance would likely cause them to gain in price at a rapidly accelerating rate, vs. a linear rate for the other choices.
It is true that the option position would lose money if in fact SPY did not drop in price by a fairly big amount, but for some traders the trade-off would be a good one. If you haven’t thought about options as a simple bearish trade, you owe it to yourself to investigate the idea.
