- Posted by Richard Croft on July 23, 2012 filed in Options Market
One can make the case that global markets have turned over and are now entrenched in a bear market phase. Global growth is slowing – particularly in China – and the eurozone collapsing under the weight of recession and political apathy. And while the US markets may be the best house in a bad neighborhood I see nothing that will stimulate economic activity until well after the election.
If you are the eternal optimist, you would argue that the market is a forecasting mechanism and the performance you are witnessing today is based on events the market expects to occur in the first quarter 2013. That might explain the US market’s resilience despite global pressures. On the other hand, even an eternal optimist recognizes that any such forecast requires one to handicap the outcome of US elections in which the Presidential race is too close to call. How do you handicap an event that will have very different implications for the US economy? Personally I see no argument that would convince me to swim against a bear market tsunami.
With that backdrop the next step is to examine strategy selection. The easiest approach is to buy puts. However, in a downward sloping market, volatility increases which pushes up the cost of an option. Making put buying inordinately expensive.
An alternative strategy is bear call spreads. These are limited risk credit spreads where the maximum return is the initial credit and the maximum risk is the difference in strike prices less the initial credit.
For example suppose we are considering a bear call spread on XYZ which is currently trading at $50 per share and the XYZ options are trading at a 50% implied volatility. The XYZ Sept 50 calls are trading at $3.75 while the XYZ Sept 55 calls are at $2.00.
I could enter a bear call spread by selling the XYZ Sept 50 calls and buying the XYZ Swept 55 calls for a net at $1.75. The net credit is my maximum profit while my maximum risk is $3.25 per share which is the difference in strike prices (i.e. 55 less 50 = 5) less the net credit received.
You might consider bear call spreads as a core strategy through the end of September.