A Trade for a Steadily Rising Market
There are a number of ways to understand the extent of the stock market’s recent up trend. In the past year, the S&P 500 has gained more than 22%. Since the beginning of the year, the gain in the index has been about 16%. These are unusually strong long term price moves.
In the short term, the price action has also been unusually strong. The chart below shows the SPDR S&P 500 ETF (NYSE: SPY) with the 20-day rate of change (ROC) indicator at the bottom. The horizontal line in the indicator pane is drawn at the 2% level.
The 20-day ROC tracks the price change over roughly the past month. At a rate of 2%, this indicator shows the stock market is moving higher at a pace of more than 25% a year, an unusually rapid advance in prices. This is not usually sustainable in the long run.
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At times like this, with prices moving quickly, it’s important to remember, as pundit Charles Krauthammer wrote, “If there’s an iron rule in economics, it is Stein’s Law (named after Herb, former chairman of the Council of Economic Advisers): “If something cannot go on forever, it will stop.”
Getting Ready For When It Stops
Knowing the stock market’s rise cannot go on forever, traders will want to be prepared for the time when it will stop.
The simplest ready to prepare for the next, and inevitable down trend, could be to buy a put option on SPY. A put option should benefit from a potential decline. However, these puts can be expensive because of the high price of the ETF.
The price of the underlying stock or ETF is an important component of an options pricing model. Higher priced stocks and ETFs will have options that trade at relatively high prices.
Volatility offers another potential trading strategy. In general, we expect volatility to rise when prices decline. This can be seen in the movement of the VIX index, an index also known as the fear gauge since it tends to rise when traders fear a decline in prices. VIX is more formally called the CBOE Volatility Index.
VIX can be directly traded with futures or options on those futures contracts. While futures are liquid markets and could be traded, many individuals do not trade futures because of the high risks associated with the markets.
VIX can be traded indirectly with exchange traded notes, or ETNs. AN ETN is similar to the more commonly traded exchange traded fund, or ETF, in that they are liquid and easily traded. ETFs and ETNs differ in their underlying holdings. An ETF holds stocks while an ETN holds derivatives.
For VIX, a popular ETN is iPath S&P 500 VIX ST Futures ETN (NYSE: VXX), a product with more than $1 billion in assets. VXX is easily traded and has an active options market available. VXX generally rises as the S&P 500 declines. This is shown in the next chart.
SPY is represented in the chart above as candlesticks while VXX is drawn as the solid line. The trends in the two tend to move in opposite directions. This has led to a sharp decline in VXX as SPY moved steadily higher.
While the simplest strategy available with VXX is to buy a call on VXX. These call options on VXX should move up in value as SPY declines since VXX and SPY are expected to move in opposite directions. However, this strategy can require significant capital since calls on VXX are relatively expensive.
A Trading Strategy for Volatility
To benefit from potential gains in the VIX index, while limiting risk, a trader can use a variety of options trading strategies. This is because options are a versatile tool that can be used to trade almost any market opinion with a limited amount of capital and limited risk, in many cases.
To benefit directly from an increase in VIX, as noted, an investor could purchase a call option on VXX. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. The risk of buying an option is equal to 100% of the amount paid to open the trade.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
For VXX, the December 15 options allow a trader to gain exposure to volatility for the next two months, a relatively long period of time for a trade. These options also have significant potential if there is a decline in the stock market before the options expire.
In general, we can expect VIX to move 3 to 5 times as much as SPY in a decline. This means if SPY falls by 1%, the VIX and VXX could increase in value by 3% to 5%. This increased leverage means that even if VXX falls in the short term, a large rally is still possible and that could deliver a profit before expiration.
A December 15 $35 call option in VXX can be bought for about $3.40 and the December 15 $37 call could be sold for about $2.90. This trade would cost about $50 to open since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $50.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in VXX the maximum gain is $1.50 ($37 – $35 = $2.00; $2.00 – $0.50 = $1.50). This represents $150 per contract since each contract covers 100 shares.
Most brokers will require traders to post minimum trading capital equal to the risk on the trade to open the position. For this trade, that would be about $150.
That is a potential gain of 33% of the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire. This means if a market selloff occurs at any time before the options expire, the trade could be closed for the maximum gain.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in Trading Tips Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.