By: Steve Smith
Thanks to the huge spike in implied volatility a ratio spread not only provides additional downside protection, you actually get paid even if it doesn’t work, giving it 99% probability of turning a profit.
Monday was one of the wildest days in the history of the stock market. It combined both a true crash with real selling on high volume with technical “flash crash” type price vacuum across broad market. Nanex, a firm that tracks high frequency trading activity, estimated there were some 4,500 mini flash crashes in the opening minutes in which individual issues dropped by 5% or more on less than 200 shares of trading volume.
The indices saw the largest round turn, from lows to highs to back down again ever; the Dow Jones was down by 1,000, actually turned green ever so briefly, only to close down by 588 points. Some individual stocks, including the largest and bluest chips like Apple or Netflix had intraday ranges in excess of 10-20% from high to low.
A picture of the S&P 500 only begins to paint what a wild day it was.
You can see the past two weeks, actually 4 days, have resolved the six month long trading range to the downside. We are now testing the old October lows near the $180 level.
It’s no surprise that such a violent move caused a huge spike in volatility. Volatility, as measured by the VIX, even though it still below 2009 peaks, it had the largest two day spike ever briefly hitting a seven year high.
So how can us option players we use these two huge moves to our advantage? A typical approach might be to establish an iron condor which consists of selling both a put and call spread. But the profit potential from this strategy is very limited and comes in very slowly because you are both buying and selling an equal number of contracts with essentially the same high IV. The other drawback of the oron condor is it is non-directional, meaning you basically want the price of the underlying to stay the same.
After what we’ve seen above (the violent break of a seven month range) I don’t think anyone can rightly expect the market, or even individual stocks, to flat line back into a narrow range. As I type this Monday night the S&P 500 futures have already traversed a 2% or 20 point range.
The strategy I’m recommending, and employed today for both myself and $20k members, is a ratio spread. This involves buying a near the money option and selling a greater number of out-of-the-money options. The goal of the ratio spread, sometimes referred to as a backspread is:
- Keep the time frame as short as possible
- Keep the width between strikes as wide as possible
- Get as much credit as possible
Obviously all these three items must be balanced and come with trade-offs. But on a day like Monday, and I think this will be true today on Tuesday, when everyone is scrambling for downside protection causing the implied volatility of puts to skyrocket, the put side of this strategy works incredibly well. You can actually get a large credit, for establishing a strong directional position, in which, even if the market rallies, you realize a handsome gain.
The best thing I can do is walk through an example.
The SPY close on Monday at $189.55, and using the SPY I’m targeting the October 2014 and today’s low, both near the $182 level as my near general downside target. This gives me the parameters for a 1×2 ratio spread in the weekly options. Specifically;
-Buy 1 August Week4 $189 put
-Sell 2 August Week4 182 puts
For a $1.20 net credit
Here is what the risk reward graph looks like:
To break it down:
The position has a maximum profit of $8.10 of shares are at $182 on the expiration date, this Friday 8/28.
Even if shares are above $189 you keep the $1.10 premium collected. That’s a decent 15% return on risk over a mere 4 day period. This is way the position has a 99% probability of turning a profit.
The big risk is if the market has another ‘crash’ and SPY shares plummet below the $175 breakeven point.
Given the devastation we’ve seen in the past few days I don’t think the market will drop another 5% in the next few days.
This position will benefit from a further decline in price, and/or the decline in implied volatility that will accompany a stabilization or rally. The only way to get hurt is another crash. And I think one a week is enough.