Option Strategy Guide It s easy to make good decisions when there are no bad option

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Sample Trade: Profit Exit RUT Bear Call Spread

Sample Trade: RUT Bear Call Spread with March 2013 options

by Vlad on February 22, 2013

Up until few days ago financial press was full with headlines like Markets are up for six straight weeks. When you hear stuff like this the only obvious conclusion should be the markets are overdue for a pullback. The way market price discovery works is prices never move in one direction for a long time. After going up for a while it need to turn around and head down and after a downslope there always should be a pullback. Its like tuning analog radio you are turning the knob waiting for the sound to get better. So it is getting better and better and is almost perfect now. Would you stop? No, you will keep turning until the you are starting to hear that cracks and noise again. The you turn around and go back. Otherwise you will never know that this particular setting is the best you can get. Now imaging tuning on a radio station that is moving from one frequency to another you will always overshot moving the knob in one direction and will be turning back searching for the new frequency, overshooting it again and keep repeating the process.

This is how market price discovery works. Somewhere under all this market noise is a fare market value which keeps changing as economic conditions change. Unfortunately nobody can say for sure what the fare market value is at any given time and market participants acting on the best of their knowledge keep moving market price around searching for it. You can never know for sure where the current market price is in relation to the fare market value but when prices moved in one direction for several weeks and everybody got excited and overconfident about this non-stop appreciation the chances are we are overdue for a pullback. We do not know how big the pullback is going to be at this point. It could be 3-5% sideways type consolidation or a 5-7% or even 10% pullback or even bigger disaster.

Certainly there is no shortage of excuses for any of these scenarios at this point. Another man main disaster called sequester is getting unraveled in Washington DC as we speak without clear resolution on horizon and definitely not by the March 1 deadline. On the other hand the actual economic effect of the sequester probably will not show up until several months later and should be relatively small at first, especially if you compare with the amount of fresh money Federal Reserve puts into economy each month in an effort to support this sluggish recovery. Overall economic indicators are not bad but nothing to write home about either. The only exception is the bond market where yields are so low at this point so prices do not have any room for upward movement but that alone should not translate to any market disaster. Overall there are no indications so far of any pressure on the fair market value in any of the direction and unless something show up we should still be looking at t tactical pullback.

The good way to play such market in the options world is by using neutral to bearish market strategy like Bear Call Spread using broad market index like Russel 2000. Neutral to bearish strategy should make money for in any type of market pullback from small sideways type consolidation to bigger over the cliff type disasters. Using broad market index should protect us from any sudden changes in the underlying security price targets based on unexpected corporate announcements. One more check before entering the trade should be to confirm the market direction change with a market sentiments indicator. I usually use 20 days moving average over an indicator showing percent of stocks in S&P 500 market index above their 200 hundred moving average. This indicator oscillates between 10 and 90 with readings below 20 indicating extremely pessimistic level usually seen at market bottoms and reading over 80 seen in overly optimistic markets due for a pullback. Change in the slope of the moving average for this indicator is a good indication in change of the market sentiments that should be a good time to enter directional type trade on the market. In this case as you can see the moving average peaked on Wednesday, February 20 and has started the gradual descent telling us it should be a good time for our trade.