Three Option Trades for a Declining Market

02/09/2010 12:01 am EST

Focus: OPTIONS

The latest stock market pullback may represent an opportunity for some traders who missed the rally. But the sentiment and market bias change has many looking for ways to hedge against a market crash. It also has some looking for the best measurement of how to make the highest-leveraged bets to profit in case the market does begin yet another serious drop. In short, there is a “fear trade” and a “greed trade.”

For the fear trade, let's look at the SPDRs (SPY), or Spyders, as a portfolio hedge against a market crash. And for the greed trade, we will be looking at the DIAMONDS (DIA) and the PowerShares QQQ (QQQQ).

Deciding how to hedge against or profit from a stock market crash depends on what stocks you own. A rule of thumb for not getting too crazy on out-of-the-money strike prices is to use the closest strike price that costs around $1.00 per contract for a balance of time value and leverage.

The most liquid instrument for traders is the SPDRs (SPY) for the S&P 500 Index. This will have the most broad market correlation to any overall downward moves. Generally speaking, most traders look for downside protection of 10% or 15% as the ripcord level. The time value is where this gets tricky, because the farther out you go, the more it will cost to buy that downside protection. Because more investors are worried about the next few months, using a June expiration here in the puts is where we are looking. Most feel that more will be known about the 2011 tax rates, healthcare, government budgets, and what financial regulations will look like by then. With the Spyders at $107 today, the JUN10 $110 PUTS at $3.75 get you very close to 10% downside protection. Technically, this is about 11% downside. 

The DIAMONDS (DIA) are more representative of the overall market now that it has fewer junky financial companies out of it, and the PowerShares QQQ (QQQQ) is the NASDAQ 100 trade. To profit from a market crash, the DJIA may offer a market play, and the QQQQ's may offer the biggest bet if technology stocks take their dive again. To profit the most and to avoid the most erosion of premium, the idea is to find the sweet spot between time value and out-of-the-money strike prices.

In the DIAMONDS, with shares around $100, and a 10,000 DJIA, we need to consider that the DIAMONDS traded under $65 at the peak of March selling last year. Going that deep is viewed by most as less likely, even in a double-dip recession, so we are looking at the SEP10 strike prices. The closest $1.00 contract is the SEP10 $73 PUT in the DIAMONDS. But the $77 strike costs around $1.40. If the DJIA drops 10% more in the next eight weeks, the value of those contracts, which is always an estimate, would be approximately $3.00. Unfortunately, if the DJIA does not drop that much, then the time erosion is going to start rapidly after the April10 options expire.

In the QQQ's, with a price close to $43, we are also going out to SEP10 in the puts. These traded down under $26.00 at the selling peak in 2009, and the closest $1.00 price strike is the $35.00 strike for SEP10 PUTS. The at-the-money puts now cost over $3.40, and using a straight line scale for the first three months of expirations would put a value of approximately $1.75 if the QQQQ drop is more than 10% before the Apr10 options expire. After the April expiration, the time value erosion will begin to pick up, and this option contract will need to be exited. If something bad in the market were to develop much faster and the QQQQ were to rapidly lose value, then this is perhaps the most leverage for the least money that actually has a chance of seeing the strike price.

Again, using options differs wildly from investor to investor. All options expire worthless, and the erosion in the way-out-of-the-money contracts seems to accelerate after the first 30% or 40% of the time expiration passes. If these stay out of the money, then the only premium will remain time value.

By Jon Ogg, contributor, OptionsZone.com

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