Don’t catch a falling knife. It’s a classic trader saying, one that most first-year trading apprentices learn through words first, then experience later. It’s a saying based on human psychology. Stocks on the way down are very unpredictable as fear and panic are stronger emotions than greed and hope.
I’ve lost enough times to learn that the falling knife usually leaves a mark. Even when you end up correct, the roller coaster ride can leave a toll. Enough that you promise not to try knife-catching again.
That’s where options come in. They provide the heavy duty gloves that make the whole exercise much less risky. In the past week, we’ve started to venture into some bullish positions on oversold names. But we’ve done it through structures that are designed not to leave too many scars if we’re wrong.
Our AAPL trades over the past week are a great example of that. All of us viewed $530 in AAPL as an important level to watch for a bounce. But none of us were too comfortable putting on outright bullish bets with the stock in free-fall. So we came up with the 1×2 call spread structure that Dan traded on Friday morning, November 9th, after we saw the stock bounce from $534.
Our hope was that the stock would have a rally up to the 200 day ma around 590-600. But we were catching a falling knife. So we used heavy duty gloves, choosing the 1×2 call spread as the much less risky way to bet on a bounce. The stock initially bounced to 555, then failed at 550 3 times in the next couple days. Again, our heavy duty gloves paid off. The knife was not done falling, but we were able to get out of the 1×2 call spread for a nice gain (with stock flat to our entry) due to implied volatility.
We still feel AAPL might be close to a bounce, BUT the knife is still falling. So we used gloves again yesterday, trading a new AAPL structure with a similar thought in mind – if we’re right and AAPL bounces, splendid; if we’re wrong, we’re much better protected than an outright bullish bet.
I have also taken a shot at catching the falling knife that is JCP. Again though, I used a low-risk structure knowing the risks.
All falling knives should be handled with extreme care. It’s an ideal situation for using options instead of trading just the stock.
Markets overnight:
- Last 2 overnight sessions have been very quiet despite the intraday volatility. Asia ex-Japan was mostly red (with the Shanghai closing near the lows of the year, down 1%), but Japan was up 2% as investors look to more stimulus post-elections.
- Europe opened slightly higher, but has been red ever since, down 0.25%. SPX futures down 0.15%, trading in a 8 point range overnight.
- The dollar and Treasury bonds are both stronger, with commodities weaker almost across the board, all small moves though.
- Industrial Production data the main economic release, at 9:15am EST