Thomas Preston is not a representative of
TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the
author and may not be reflective of those held by
TD Ameritrade, Inc.
For more on the risks of trading and trading options,
see page 37, #1– 2.
to put as many factors as you can in your
bearish trade’s favor.
Past performance of any stock or index
is no guarantee it’ll deliver similar performance in the future. That means bullish
markets might not last as long as they have,
and bearish markets might last a lot longer
than they have. With that caveat, let’s assume as an example that you are bearish,
and you think a market drop in the future
might be similar to ones in the past 10 years.
One strategy you might avoid is simply
buying a put. Yes, a long put has negative
deltas and is a bearish strategy. But if put
prices are relatively high due to the skew
and market expectations of a crash, you
could be paying a lot for that strategy.
A way to take advantage of the higher prices of OTM puts could be to use them as the
short leg of a long put vertical, which is long a
put at a higher strike and short a put at a lower strike in the same expiration. If you buy
a put that’s near the at-the-money (ATM)
strike, and sell one that’s further OTM, you’d
be buying a put with a lower implied vol (IV),
and selling a put with a higher IV (Figure 1).
The skew is in your bearish trade’s favor.
Obviously, if the index moves the way you
think it will, you want your trade to be prof-
itable. But some trades react more favorably
than others. Typically, a long vertical like
the one just described would be expected to
increase in price if it has fewer days to expi-
ration. That’s because the long ATM put has
high positive gamma, which manufactures
negative deltas quickly if the index falls. And
gamma is higher with fewer days to expira-
tion, all things being equal. A long put vertical
with more days to expiration would also like-
ly increase in price if the index falls, but not
as much. So, if you think the market might
sell off quickly but possibly rebound, a long
put vertical with fewer days to expiration
could potentially capture higher profit than
one with more days. That’s putting the power
of positive gamma in your trade’s favor.
The downside? If you want to maintain a
bearish position, you may need to roll a vertical with fewer days to expiration to one with
more days, which incurs commissions and
transaction costs. So, consider balancing the
benefits of fewer days to expiration against
the extra transaction costs from rolling by
using an expiration that might have 30 to 60
days to expiration. A long put vertical in one
of those expirations won’t respond as quickly as one that expires in five days, for example, but you won’t have to roll as frequently.
Now, if the index does have what you
consider to be a big drop in a short time
frame, consider taking smaller profits
more quickly before the index bounces
back. Don’t wait around to see if the index
has another massive ’87-style crash. The
risk, of course, is giving up potential profit
if the index drops more. But if you believe
the index might resume an inexorable
grind higher, then it may make sense to
take, say, 50% of the max potential profit of
the long put vertical when you can. You’ll
capture some profit (eliminating the risk
of giving up all the profit) even if the index
rallies back quickly and the trade turns
into a loser. In other words, take the profit
the market gives you, before it takes it
away. And don’t be greedy. That’s putting
the exit strategy in your trade’s favor.
FINALLY, KEEP YOUR TRADE SIZE SMALL.
Being a bear in a bull market can be a lesson
on how to take losses. Don’t let them destroy your account by trading too big. That
way, you can make sure the bull only steps
on your bear’s paw, rather than squashes
him. And, once in a while, you give the bear
a chance to chase the bull around.
FIGURE 1: Implied vol for both legs. From the Analyze tab on thinkorswim, look up the option
chains and analyze the IV, gamma, and deltas of different strikes and expirations.
Source: thinkorswim® from TD Ameritrade. For illustrative purposes only.
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IN YOUR BEARISH
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