“I think it has found a bottom but what if it hasn’t?” In all my years trading, this question came up most frequently after big market sell-offs and challenged me to find a strategy that would work no matter what the future trend.
Finding a bottom is a precarious task because it can quickly evolve into “catching a falling knife”. The allure of picking that single point in time when the demand from stock purchasers overwhelms the distribution pressure from sellers is too attractive for most of us to ignore. But many of us have been stung in the past from ambitiously (or recklessly) purchasing long call options so a more sophisticated strategy is warranted.
As Phil has mentioned often in his hedging strategies, 100% bullish doesn’t mean populating an account with 100% call options or stock holdings. As optimistic as we may be that a bottom has been found, prudent risk management necessitates hedging the long call positions. That leaves us with the choices of adding short call options or long put options. If we truly believe a bottom has been found then limiting our upside potential through the addition of a similar number of short call contracts defeats our purpose (making BIG money) for entering the trade!
As a result, we prefer to enter long put options against our long call options (same number of contracts for each set of options). However, this trade is essentially a straddle (if both long call and long put strikes are the same) or a strangle (if the long call and long put strikes are different). Straddles are smart plays on volatile stocks but they tend to be delta neutral at the time of trade entry. Therefore, the trade doesn’t make much money until the stock breaks significantly up or down.
This forces us to return to our original premise – the stock has found a bottom – and our goal: to make a lot of money if the stock returns to old highs while ensuring risk is carefully managed if stock drops a lot or moves sideways. The straddle/strangle can be adapted to include this sideways scenario. We can add shorter term short puts against our longer term long put options to reduce the cost of the trade and to benefit from the stock moving sideways as it tries to form a bottom. But how many contracts should be entered?
The trade so far has the same number of long call and long put contracts but we haven’t addressed how many short put contracts are needed. If we place the same number of short put contracts as long put contracts, we end up with a put calendar trade. This is fine if the stock stays flat or drops slightly but will certainly not please us if the stock drops substantially. Instead we can add a reduced number of short put contracts against our long put contracts. For example, if we were to place a trade that had 10 long calls and 10 long puts, we could add 5 short puts against those long puts. Those short puts reduce the cost of the trade to a degree, they make us money if the stock moves sideways and they only hinder 5 of the 10 long puts from protecting our long call contracts in the event of a sharp decline. Is it okay that we don’t have an equal number of long puts protecting our long calls?
It depends! It is fine if the premise behind our trade is to bias the trade bullish and still protect ourselves somewhat during a big decline. (In contrast, the trade would be too aggressive if we had no idea which way the market was going!).
An attractive aspect of this strategy is that if the stock really falls off a cliff, those additional long put options keep making money whereas the long call options can only drop to zero. As a result, even if the original thesis for entering the trade is proven completely wrong by the stock going sharply in the opposite direction the trade can still make money if the stock moves far enough. If the stock doesn’t move much at all initially, the short puts will expire worthless and additional short puts can be entered in the next expiration month. Meanwhile if the stock rises aggressively, another 5 short puts can be entered against the original 10 long puts, perhaps even at a higher price, creating a relatively complex diagonal put spread with appreciating long calls.
From a technical standpoint, technical trends in which the moving averages are pointing sharply lower are usually not ideal for this application. In our application of this strategy we tend to choose stocks that have already come down substantially and are testing strong technical levels and preferably attractive fundamental valuation levels.
Have a fantastic week!
OptionSage
