December 6th, 2022

The Option Technique You Should Know Before The Market Breaks Again

Well, here I thought this week was going to be calm. Stronger-than-expected economic news sent bond yields soaring. The general consensus is that the Fed will need to keep interest rates higher for even longer as we fight against persistent inflation.

China accelerated a shift towards reopening the economy and their stocks railed to a 2-½ month high. Instead of providing positive news about global demand, it sent the U.S. markets into a free fall.

The selloff back in the U.S. was felt across all sectors, with energy taking the biggest hit.

With the Fed meeting coming up next week, we won’t be hearing from any of them this week. Despite the news out of China, the market is still anticipating a 50 basis point increase next week from the Fed instead of 75.

News aside, the SPY chart came up to resistance and the second wedge pattern since August. The first wedge resulted in the market headed lower. The market is getting coiled up here with higher highs and higher lows in the short term, but slamming up against long-term resistance. Where are we going from here? I don’t know, but I suspect there will be a major move in either direction soon.

How can you take advantage of a wedge pattern? If there’s a time when you don’t know which direction the market is headed, but you’re anticipating a major move, you can use an options technique to your advantage.

Here’s how…

This is for an example only and is not a trade recommendation that will be tracked.

If we were bullish only about the market, we’d buy a call. The option appreciates in value with every move the underlying makes to the upside.

Conversely, if we were bearish, we’d buy a put that would appreciate in value with every move the underlying makes to the downside.

What if we don’t know where it’s going, but we just think something big will happen?

The SPY is trading at $399.59 and let’s assume we think it’s going to break out of the wedge and move in one direction or another in a major way. The last time this happened, the market fell by 10% in a month.
A straddle options strategy involves buying both a long call and a long put at the same strike price and using the same expiration date.

But wait! If you buy a call and buy a put, won’t they cancel each other out?

Let’s see what the risk profile looks like if we set up a trade where we buy the 20 JAN 23 $399 call and the 20 JAN 23 $399 put.

The teal line represents the profit/loss at the time of expiration and the purple line represents the profit/loss as of today.

Since you’re buying two options, the max loss is the amount you spend for both options. In this case, it’s $2296. But if SPY breaks out and moves 2% by this Friday and goes up to $408, the two options combined give you a net profit of about $83. That would be a 3.6% return with a market move of only 2%.

Now, what would our straddle be worth if the market breaks down again by 10%? Our straddle would be worth an estimated $1700 after one month with a similar downward move in SPY.

Let’s continue, assuming the market is headed lower, but again, not a recommendation… Where could the market go? Let’s look at Fibonacci ratios.

The likely pivot points are $389, $377, $367, and $357. If SPY broke down by January 1st, you’d be looking at a $2 profit, $450 profit, $1131 profit, or $1940 in profit, respectively.

You can potentially increase that by selling the call right after the break if you think the market will continue lower. There’s no point in keeping both options once the market shows a new direction.

Straddles can be useful around news-related events as long as the IV rank is low. The higher the rank, the more elevated option prices will be and you’ll be buying “expensive” options.

For example, straddles can get expensive around earnings because everyone is assuming big moves in the market, so options are priced higher. The more expensive the option is, the bigger the move in the underlying is needed to overcome the initial cost.

Remember, option prices decay with time and you’ve purchased two options, therefore time is not on your side. You need a big move and fast. Be ready to bail if you’re not getting a nice move. Time will eat this trade away. If you buy short-dated options, the theta decay is going to be really high and that means you’ll need an even bigger move.

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Jeff Wood

Editor, Filthy Rich Dirt Poor

Trader, Options Testing Lab