5 Steps to Trading The Week Ahead

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Step 1:  Research Event Calendar

Bear Stearns Earnings Sep 20 (BMO – Before Market Opens)

Goldman Sachs Earnings Sep 20 (BMO – Before Market Opens)

Morgan Stanley Earnings Sep 19

Lehman Brothers Holdings Earnings Sep 18

Sep 18 FOMC Policy Statement

Week of September 17 – September 21

Step 2:  Determine Outlook

Both the VIX and the S&P500 have been trending in the same direction recently.  This is not the normal condition.  More often than not, the VIX moves opposite to the direction of the market.

This may be due to deep-pocketed investors buying ahead of an expected rate cut this week, while the rest of the market remains fearful of the extent of the sub-prime issues, the effect of a cut on the dollar, the global impact and so forth.  Some might argue that the relatively low volume on the uptrend recently can be traced to shorts covering positions ahead of the Federal Reserve announcement.

Whatever the reason, my expectation is for volatility in the upcoming week.  (I often ask myself what is the one thing everybody expects because the opposite often comes true!  During this upcoming week, however, I believe too many news events are packed tightly together for the market not to react).

Step 3:  Select a Stock

Since a volatile market is expected, it makes sense to choose a stock that is expected to display volatility also (we will see why this makes sense in the Step 4).  This leads me to consider stocks that have been punished on concerns of sub-prime issues – Goldman Sachs, Lehman Brothers, Morgan Stanley, Bear Stearns.

Although a degree of opacity associated with the internals of these companies prevents a clear insight as to which is categorically the weakest of the four, my preference is to choose Bear Stearns on account of the recent 4 month stock volatility.

Step 4:  Select a Strategy

Straddle, strangles, ratio spreads, ratio backspreads and combination plays all offer opportunities.  For the upcoming week, a call ratio backspread offers an interesting play.  This trade can be structured as follows (with equal number of contracts on all strike prices).

Sell Strike 110 September Short Call Credit $9.10

Buy Strike 115 September Long Call Debit $5.80

Buy Strike 125 September Long Call Debit $1.75

Net Credit = $1.55

Risk = $3.45

If the stock moves below $110 at expiration, all options will expire worthless and the maximum credit of $1.55 will be kept.

If the stock stays between $115 and $125 at expiration, both the bear call aspect of the trade and the additional long call will lose value, hence the maximum loss of $3.45 will be incurred.

If the stock rallies above $125, the bear call will be at a maximum loss but the additional long call can continue to profit as the stock climbs higher.

Step 5:  Determine Exit Strategy

This is a speculative strategy that has a relatively low dollar risk, $3.45 per share but a relatively attractive return on risk, 44.9%, in the event that the stock moves well above $125 or below $110.  If volatility is expected, this return is eminently possible but if the volatility fails to materialize, the risk of $3.45 per share must be accepted as a potential loss ahead of time.  

Trade Safely!

OptionSage