Sliding Down the Fiscal Cliff

11/29/2012 8:00 am EST


Mark Sebastian

Founder, Option Pit LLC

As the cliff gets ever closer, expect a raft of more cliff-related trading strategies to pop up. Here, Mark Sebastian of has constructed a sample short-term bearish trade.

At Option Pit, our goal is to teach our option mentoring students not just the strategy, but the theory behind why one would execute a strategy. We want our option traders to learn how to construct their own trades, not just regurgitate others' trades. Here is an example:

We currently believe that, when a debt deal is reached, the market is going to make a massive run higher. Especially if the deal gives US corporations some actual clarity as to what tax and regulatory structure is going to be. However, in the near term, we are believers in a directionless market that will creep higher when politicians aren’t talking and sell of when they are. Now that the market has rallied back over 1,400, we think it’s about time for a Republican or Democrat to open his or her mouth and send the markets down 1% or so. Not down to 1,300, but maybe testing 1370ish again.

So how should one set up a bearish trade? First let's look at overall vols in the SPX:

LiveVol Execution®
Click to Enlarge

The VIX and, overall, S&P IV's are still generally below recent levels. At the same time, the term structure is relatively tight between near- and far-term contract months. Notice how tight the 30-day and 60-day IV are right now. This makes me think two things:

1. Long Vega
2. Term Structure Trade

Now, pulling up the term structure, we can clearly see where IV's are heavy and light. It is, in relative terms, expensive to own near-term options (gamma) and cheap to own Dec31 and Jan Expirations (vega).

LiveVol Execution®
Click to Enlarge

Based on the structure and vol, we are going trade an OTM calendar. One could go as low as 1,375, but based on skewness in the near term, I am going to set up this one right around 1,385. We pay less than 10.00 for the spread. The trade ends up being December expiring next Friday vs. the Quarterly Dec. Although, the January or February options would have just as easily worked.

LiveVol Execution®
Click to Enlarge

Our goal is for the market to drop its 1% right into our calendar, or if it sits here and meanders, collect the Dec7 decay. At that point, we roll back.

The Trade:
Buy an OTM calendar if bearish vs. a butterfly or even a call credit/put debit spread.

By Mark Sebastian of

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