You may have noticed a trend in some of our trading lately, buying outright puts near what we feel are inflection points adter market bounces/rallies and not spreading them right away, but rather waiting to see weakness first before spreading. I wanted to explain the thinking about this and talk about trade managment in two such trades, XRT and XLB.
Buying long premium outright for directional trades is not a strategy we typically recommend as over time this will certainly be a losing strategy. We generally look to finance directional trades entirely (in the case of a collar of a risk reversal) partially (in the case of a call spread, put spread, or out of the money butterfly) or in a rolling fashion (in the case of calendars).
But what we’re seeing now in the market is fairly unique with continually elevated vol and what seems like a tradeable range in implied volatility (as seen in the VIX) over the past few months:
Basically what that chart is showing you is that when the market is in the midst of one of its recent selloffs, it get to about 30 VIX before a bounce. On the flip side after one of these rallies (that we feel are countertrend rallies) the VIX gets down to about 20 or slightly below.
So what that means for our options trading is that when we feel it the market is at a potential inflection point following a rally, vol is low and is likely to quickly spike if we do indeed get a selloff. That means we not only get the benefit of legging the deltas of the put spread, but also get the benefit of vol that has been spiking significantly from 20 to 30 (or 50%) on these selloffs.
So it pays to wait to spread, but only if you can time the market well. Therefore the flip side of legging into these trades by simply starting with an non spread put purchase is that if the entry is wrong we need to keep a tight leash on it and take the losses (hopefully at less than 50% premium lost).
So to XRT and XLB, these were two sector shorts we put on on Friday. To recap, here were the puts we bought:
*XRT ($41.30) Buy the March 41 puts for 1.15
*XLB ($40.75) Buy March 40 Put for 90 cents
The XRT etf is slightly higher from where we bought the put, making the put a slight loser. The XLB etf is slightly lower from where we bought the put, making the put a slight winner. So these are two good examples to compare the merits of our current strategy and how we’ll have to manage. Basically, both puts are still out of the money, so they’re entirely extrinsic premium. That means both are at risk of losing all the premium if the etfs don’t break down from here.
So for management purposes we need to keep a tight leash on the XRT puts. If XRT holds here and drifts higher we’ll need to close it. Right now it’s worth about .75. To be disciplined we shouldn’t let that get below 50 or 60 cents. At that point we should just sell it for the loss. If the market does break down here we’d look to spread, perhaps with the 39 puts.
XLB is a slight winner, worth about 1 after paying .90 originally. We would look to spread this on weakness, possibly by selling the 38 puts and having a cheap $2 wide put spread. But the same rule applies if it holds here and goes higher but perhaps with an even tighter leash as we’d have the chance to get out for a very small loss.
So this strategy is riskier than we normally like to play for weakness, but the tradeable range we’re seeing in implied volatility and what we feel are counter-trend rallies has us taking a little more risk on bearish positioning here.