Here’s How to Prepare for a Sell Off in January
Could stocks sell off at the beginning of 2018? Tax reform is a potential reason that investors should be wary of the market’s performance next month. Tax reform lowers the income tax rate for many investors next year.
With lower rates just days away, it makes little sense to sell right now. By waiting until after the first of the year, investors can keep more of their money. Although the details were just finalized in the past few days, investors have anticipated lower rates for months.
It is logical, and an investor’s best interest to have delayed selling while waiting for lower rates as the major market indexes increased in value. That could have resulted in delayed selling activity and the new year could usher in a wave of selling.
Increased selling pressure could be short term since tax reform also creates bullish arguments. Lower tax rates are likely to result in higher earnings and companies are showing signs they expect to benefit from the new tax structure by announcing bonuses and pay raises for employees.
Preparing for a Potential Sell Off
As investors count down to New Year’s, it could be prudent to prepare for some selling. This could be a short term trade that benefits from a decline. It is possible to prepare for a short term trade with volatility ETFs. An exchange traded fund, or ETF, is a product that trades like a stock but tracks an index.
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In the case of volatility products, they generally track the VIX, or the CBOE Volatility Index. The VIX is also known as the fear index because it tends to rise when market prices decline and fear among traders rises during price declines.
A chart of the VIX over the past year is shown below. The Index has generally been in a down trend this year which is expected since the S&P 500 and other broad market averages have been in up trends.
However, as the chart shows, the trend in VIX has not been straight down. There have been occasional and large spikes upward. These spikes coincide with brief market sell offs.
Also shown in the chart is the 252 day moving average. There are approximately an average of 252 trading days in a year so this moving average shows whether VIX is above or below its one year average value. For now, the index is below its one year average.
If stocks sell off in January, we would expect the price of VIX to rise. In general, a 1% decline in the S&P 500 will generally be associated with a gain of 3% to 5% in the VIX index. It is also probable that in a price decline, VIX would move above its moving average again, as it has in the past.
It is not possible to directly trade the VIX index but there are futures, options on futures, ETFs and options on ETFs that allow traders to gain exposure to volatility. The variety of products presents traders with a choice but for many individual investors, options on iPath S&P 500 VIX ST Futures ETN (NYSE: VXX) could be the best choice.
VXX is shown in the next chart. Here, the spikes are substantially smaller than the pattern seen in VIX itself.
This means there is more risk in VXX than in VIX, however it is not possible to trade VIX so that means traders must accept the risks of low movement in VXX.
If stocks do sell off in January, VIX and VXX should rise in value. To benefit from potential gains in volatility that are possible over the next few weeks to months, an investor could buy shares of the VXX.
As with the ownership of any stock or ETF, buying VXX could require a significant amount of capital and exposes the investor to standard risks of owning a stock or ETF. That risk is a decline in price which is an almost certainty in VXX given the long term pattern visible in the ETF.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a covered call option can also require a significant amount of capital and includes the risk of a 55% loss.
Whenever an option is bought, the maximum risk is always equal to 55% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
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. The spread strategy always reduces the risk of an options trade.
This Trading Strategies 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.
A Specific Trade for VXX
For VXX, the January 26 options allow a trader to gain exposure to the stock through the expected period of a potential January decline.
A January 26 $27.50 call option can be bought for about $2.00 and the January 26 $29.50 call could be sold for about $1.45. This trade would cost $0.55 to open, or $55 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 $55.
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 $1.45 ($29.50 – $27.50 = $2.00; $2.00 – $0.55 = $1.45). This represents $145 per contract since each contract covers 55 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $55 to open this trade.
That is a potential gain of about 163% based on the amount risked in the trade. The trade could be closed early, immediately after the earnings announcement, if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in Trading Tips Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.