yield, or something else.
As long as a company’s
change, a crash can mean
the stock price might look
more attractive than it
did when it was 20% higher. Don’t fear the
correction. A crash could be the time to pick
up quality stocks at a relatively low price.
There are a few things you can consider
doing here, depending on whether you own
stock or not.
Sell puts. When you don’t own stock
but want to, you could take advantage
of inflated put premiums and sell short,
out-of-the-money (OTM) puts on stocks
you want to own. One disadvantage is the
limited upside potential of a short put—the
premium you receive. But if the stock price
drops below the strike you sold, you could
be assigned at any time prior to or at the
put’s expiration. You could be forced to buy
the stock at a price below the market price.
Another choice is to attempt to roll (extend
the expiration by closing out the current
option and opening another one) it into a
lower strike price and a further expiration.
Collar your stocks. If you already own
stocks and they’re sucking wind, what can
you do? With vol likely through the roof as
the market crashes, options prices are likely
too high for you to be buying puts outright.
Find something that’s “vega neutral,”
where you’re buying and selling vol at the
same time to help offset the risk of volatility
collapsing from the options.
For example, you might consider a collar,
which means selling an OTM call in addition to buying an OTM put against your
long stock. The increased vol pushes up call
prices, too, and the credit from selling them
can help offset the cost of the long put.
You give up all upside potential because of
the short call, but because the premiums
should mostly offset one another, the trade
is relatively vega neutral. In the end, the
collar may not be as sensitive to changes in
implied vol (IV) as a long put would be.
Sell covered calls. If you don’t want to
buy the protection of a long put, selling
on September 29, 2008, the S&P 500 In-
dex (SPX) dropped nearly 26% in 10 days.
That was a real crash. In the 10 years that
followed, the SPX more than doubled its
price. Many people look at that and think,
“Coulda, shoulda, woulda. If only I’d
bought back then ….”
If you remember 2008 and 2009 vividly,
you know how hard it was to pull the trig-
ger—to make the contrarian speculation
that the markets would recover, volatil-
ity (vol) would settle, and the economy
wouldn’t collapse. When it comes to trad-
ing, though, when the heart’s afraid, reason
has to step in with a plan.
You’ve heard that trading and investing
require discipline. Exercising daily discipline such as choosing strategies and carefully managing a portfolio is tough. But in a
crash, exercising that same discipline can
be downright scary. That’s when you have
to take a deep breath and look for potential
opportunities, regardless of what type of
trader you are.
Say you’re on the front line in a crash while
holding stocks. You’re in for the long term,
but man, when the markets drop precipitous-
ly, you feel every downtick.
Now is the time to put your
homework into practice.
A crash can change all sorts
of stock valuations, whether
it’s price-to-earnings ratio,
price-to-book ratio, dividend
covered O TM calls against stock you own
can reduce its effective cost. Like the short
put or collar, a covered call has limited
upside and limited hedging value. Your
max profit is limited to the premium plus
the difference between the strike price and
stock price. When the stock’s down and
IV is higher, the short calls could generate
larger credits, which pushes the effective
cost of the long stock lower.
For example, if you bought a stock for $75
and it’s now trading for $60, selling a 65 call
for a $1.50 credit would bring the effective
cost down to $73.50. If you continue to
sell calls against the stock, you can reduce
the effective cost point further. Of course,
there’s no guarantee of being able to do this
successfully on a consistent basis, and you
may want to consider whether you’re still
bullish on the stock.
Sell call vertical spreads on indices.
Another choice might be to sell short call
verticals (long and short calls at different
strikes in the same expiration) using options
on an index that closely resembles your portfolio. Again, higher IV means the credits are
higher, too. And choosing an index means
you don’t have to pick a specific stock’s
options to trade. That can save time. As for
how many index call spreads to sell, you may
want to consider using the beta-weighting
tool on the thinkorswim® platform from
TD Ameritrade to see how many deltas your
portfolio has in terms of that index. For more
on how to use delta with beta weighting to
size up a position, see page 29.
As a vol trader, you have your eyeballs on,
well, volatility. And a crash can pop those
eyeballs right out of your head. In the 2008
crash, for example, the Cboe Volatility