Bad timing? Risk-averse? Try OTM Options

By Vikram Rangala

What I’m going to recommend is so simple it will make some of our experienced option trading readers cringe. So to all of you hedge fund and prop desk folks and veterans of every stripe, I apologize in advance. This isn’t selling covered calls above a long stock or futures position, this isn’t about iron condors or bear put spreads. This is as simple as it gets.

With stocks having made a new high yet again, the inevitable predictions of a crash are making the headlines. Larry Fink, the head of Blackrock, one of the largest investment firms, recently called the economy “bubble-like.” The same NY Post article (consider the source) points out that even CNBC has been getting more pessimistic. Well, we can’t ask for better evidence than that.

As one of the many traders who watches CNBC, if at all, with the sound muted, I think about the old adage, “If it’s news, it’s old.” (How old is that adage? About 20 seconds old, but I’m hoping it becomes a thing.)

E-mini S&P 500 Dec 2013

Punditry aside, the stock market is due for another correction. It has been moving through the long rally of 2013 in 6- to 7-week waves. The Russell’s waves have been gentle; the Dow, ever the drama queen, has had large chops. But if that 7-week pattern continues, then we are due for another drop to about 1680 in about the 3rd week of November.

Note my use of the word “about.” About is the best we can do. Even Roger Babson, who predicted the 1929 crash a year in advance, could only say about when it would happen. So what do you do when you have no reliable way to pick the top and, besides, as a smart trader, you don’t try to pick tops and bottoms? And how do you limit the risk of being wrong about the correction, while still being able to profit from it if and when it happens?

The simple answer is, buy cheap, out-of-the-money puts. Yes, there are more sophisticated option strategies. You could sell covered calls and keep selling more above the rising market, but once you’re in that game, even success can be stressful until you get close to option expiration.

Option spreads are great, too, but you limit your profit and face unlimited risk on the option you sold. That doesn’t make it a bad idea, either, just one that needs to be managed carefully.

Cheap OTMs have the added attraction of being, well, cheap. You know your maximum risk up front. True, an out-of-the-money put option won’t go up in price tick for tick the way a futures contract or in-the-money put will. But the leverage on a big move is unbeatable.

A put option in the E-Mini S&P 500 Dec 13 (ESZ13:CME) with a strike price of 1600 could be had for less than $300. Less than three weeks ago, before this latest wave up, that option was $1600. It has 50 days left until expiration, so it still has a few good weeks before it loses its extrinsic value to time.

It helps further to pick something a little more expensive than what you want to pay. Then place an order at a price below the current one. Even just bidding half the current price can work. Then you wait and let the market come to you. Sometimes it happens quickly; sometimes you wait days or even weeks.

But the rewards for your patience are several. First, you risk only what you want to risk. If the trade never becomes as low-risk as you wanted it to be, then it never was the trade you wanted. It simply failed to meet your terms of engagement. Make a new plan or find a new market.

The biggest challenge here is resisting the urge to toss aside your plan because the market seems to be starting its move without you and jumping the gun. Sure, sometimes you catch a trade at the last minute. But more often, you buy the option and then realize it was a head fake, and you are now the proud owner of a depreciating asset.

Second, you can have the world’s lousiest timing and still be in position for the big move. Even if the market continues upward (in the example of puts in the E-mini), you only lose at most the price of the option. It might go to zero, but never lower. And if there is still plenty of time left on the option, then there is plenty of time for that top to eventually happen. When it does, the option will come back to life and you will already be in the market for the profitable ride down.

We’ve all fallen into that terrible mistake of holding onto a loser, hoping and praying for it to turn around. Often it does, but not before decimating our account. Here you get to do that holding on, but the risk to your account is fixed and you decided ahead of time what that risk would be.

Finally, you get the reward of tremendous leverage. Because you bought it (or them) so cheap, when the market moves closer to the option’s strike price, the option premium rises at a faster rate. 200%, 300% and even higher returns are not uncommon. When you hear a trader talk about having triple-digit returns, chances are he or she had some options in that portfolio.

Simple as it may be, buying options is sort of like buying insurance. You can’t be sure when a disaster might happen or even if it will happen during the life of the policy. But you want to be covered in case it does happen. Nobody can predict when or even if the stock market will have a major drop. But if it happens, for a low risk, you can insure, or ensure, that you’ll be in a position to profit. Combine this strategy with any day-trading or stock or futures position or swing trading you might do.