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COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!

It would be an understatement to say that a lot has happened since my last two Fast Break articles published in 2008. In the April 30, 2008 article, "Sell Credit Spreads in this High Volatility Environment," I discussed how volatility had increased dramatically since the early part of 2007. I showed how this higher volatility translated into higher premiums for credit spreads and I then proceeded to recommend selling specific call and put spreads. In the June 20, 2008 article, "Continue Selling Credit Spreads in this High Volatility Environment," I reviewed the successful trade from April and went on to recommend call and put spreads (also successful) to sell over the summer. We all know that this was the calm before the storm and that the bottom fell out of the market in the fall. If you had been in similar trades at that time the call spreads would have been winners, but the put spreads would have lost at least 5 times what you would have made on the calls, thus turning the overall trade into a big loser. In this article I will review trades I made for clients in the fall and show how you can be short volatility and long volatility at the same time. I will then go on to recommend a trade for the next few months.

First let's recap. For the first 8 months of 2008 the S&P500 traded in a nice range between 1200 and 1440. This was a perfect time to be selling calls spreads above the market and put spreads below the market. If you had been successful with this strategy and had not foreseen the meltdown just around the corner you might have continued selling calls spreads above and put spreads below the market and steered yourself into a perfect storm. In September that is exactly what I did. Fortunately, I bought a lifeboat before the storm hit.

Looking back on an actual account here is what happened. On the close of business for September 24, 2008 here is the position I had.

Short 10 November 1300/1340 call spreads. Closing price:  7.70 points.
Short 10 November 1100/1140 put spreads. Closing price:  11 points.
S&P500 closed at 1185.

On September 30, 2008 I decided to buy some extra puts (the lifeboat). I had no idea what was about to happen, but figured I would spend some money for some relatively cheap deep out of the money puts that should do well if the market collapsed.

I bought 5 November 850 puts for 4.50 points.

I have been calling these puts "insurance puts" because they would only pay off if there was a disaster. Well, many would consider what happened in October a disaster.

As you know, at the end of September this account was short 10 call and put spreads while long 5 deep out puts. Most would consider this a short volatility position in which we would hope for the market to stay in a range so all the options would expire worthless and we would keep the premium. As you will see, what happened next turned this into a long volatility position where the long puts made all the difference between a loser and a winner.

If you cannot view the S&P500 Chart, go here.

The S&P500 cash index closed at 1164 on September 30, 2008. Over the next eight trading days from October 1-October 10 the market fell every single day and hit a low on October 10 of 840 before closing at 899 that day. This 324 point drop from 1164 to 840 represents a 27% move to the downside in less than 2 weeks! During this time the VIX almost doubled, going from 40 to an all time high of 76! I do not have the time or the energy to look back into history, but I think it would be safe to say that moves of this size in such a short period of time have not happened often.

If you cannot view the VIX Chart, go here.

Let's take a quick look at what I did with the positions and how it all worked out.  As the market started to fall precipitously the call spreads started to lose value, but the put spreads started to gain even more. Meanwhile, the deep out puts started slowly to gain value and volatility premium. On October 6 with the market trading around 1050 I bought back the ten call spreads for 1.4 points. Closing them made sense because they had lost most of their value. At this point in time, though, the puts had gained a lot of value. The spreads closed at 24.5 points while the 850 puts closed at 13.40 points. The account's overall value was approximately $7,000 worse than it was on September 24^th.

As the market continued to fall and volatility continued to increase an interesting thing began to occur to the premiums. The deep out puts began to increase rapidly and since owning 5 of them meant essentially being long volatility this was a good thing. Obviously, as the put spreads went deeper into the money they increased also but, as spreads, there was a limit to how much that could hurt.

Here is a little chart of the closing prices over the next few days.

October 7	S&P 996	Spreads 29.4	Puts 20.4
October 8	S&P 984	Spreads 30.9	Puts 28.1
October 9	S&P 910	Spreads 35.2	Puts 48.3

On October 10^th, with the market in apparent freefall, I took action. I sold the 850 puts for 66 points and closed 5 of the put spreads for 37 points. I subsequently bought back the other 5 put spreads for 37 points. The end result was that the call and put spreads lost approximately $50,000 while the 850 puts made $75,000 for an overall profit of $25,000. As you can see the puts I purchased saved the day. They turned a potential big loser into a winner. They turned a short volatility position into a long volatility position in a matter of days.

NEW TRADE

On January 30 The S&P500 closed near the 825 level. The VIX is approximately 45. I definitely like selling credit spreads in this environment. There is beefy premium and we do not have to go out a long time to collect it.  The spreads I recommend below expire in 7 weeks. Time decay should start to pick up over the next few weeks. I will also recommend purchasing and extra put just in case another meltdown occurs.

All prices and margin requirements are based on the close of business on Friday January 30, 2009.

Sell 2 March 920/950 Call Spreads
Premium :  5.10points x $250 = $1,275 x 2 = $2,550

Sell 2 March 660/700 put spreads
Premium: 4.8 points x $250 = $1,200 x 2 = $2,400

Buy 1 March 500 put
Premium: 1.65 points x $250 = $412.50

Premium collected (not including commission and fees): $4,537.50
Initial margin requirement: $5,000
Expiration Date: March 20, 2009

Mr. Jonathan Lubow graduated from Dartmouth College in 1989 with a BA in History. He has had uninterrupted registration with the National Futures Association since 1990. Prior to co-forming Trader's Edge in 1998, he was the number one broker for his firm for five straight years. At Trader's Edge, a commodity brokerage firm in New Jersey, he maintains the position of vice-president while still trading and servicing customer accounts.

Mr. Lubow is married with two daughters and resides in Morris County, New Jersey.

COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!