An Option Strategy for Trading Market Bottoms

High volatility associated with stock-market bottoms offers options traders tremendous profit potential if the correct trading setups are deployed; however, many traders are familiar with only option buying strategies, which unfortunately do not work very well in an environment of high volatility.

Buying strategies—even those using bull and bear debit spreads—are generally poorly priced when there is high implied volatility. When a bottom is finally achieved, the collapse in high-priced options following a sharp drop in implied volatility strips away much of the profit potential. So even if you are correct in timing a market bottom, there may be little to no gain from a big reversal move following a capitulation sell-off.

Through a net options selling approach, there is a way around this problem. Here we'll look at a simple strategy that profits from falling volatility, offers a potential for profit regardless of market direction and requires little up-front capital if used with options on futures.

Trying to pick a bottom is hard enough, even for savvy market technicians. Oversold indicators can remain oversold for a long time, and the market can continue to trade lower than expected. The decline in the broad equity market measures in 2009 offers a case in point. The correct option selling strategy, however, can make trading a market bottom considerably easier.

The strategy we'll examine here has little or no downside risk, thus eliminating the bottom-picking dilemma. This strategy also offers plenty of upside profit potential if the market experiences a solid rally once you are in your trade. More important, though, is the added benefit that comes with a sharp drop in implied volatility, which typically accompanies a capitulation reversal day and a follow-through multi-week rally. By getting short volatility, or short vega, the strategy offers an additional dimension for profit. (See also: Implied Volatility: Buy Low and Sell High.)

The CBOE Volatility Index, or VIX, uses the implied volatilities of a wide range of S&P 500 Index options to show the market's expectation of 30-day volatility. A high VIX means that options have become extremely expensive because of increased expected volatility, which gets priced into options. This presents a dilemma for buyers of options—whether of puts or calls—because the price of an option is so affected by implied volatility that it leaves traders long vega just when they should be short vega. (See also: Volatility's Impact on Market Returns.)

Vega is a measure of how much an option price changes with a change in implied volatility. If, for instance, implied volatility drops to normal levels from extremes and the trader is long options (hence long vega), an option's price can decline even if the underlying moves in the intended direction.

When there are high levels of implied volatility, selling options is, therefore, the preferred strategy, particularly because it can leave you short vega and thus able to profit from an imminent drop in implied volatility; however, it is possible for implied volatility to go higher (especially if the market goes lower), which leads to potential losses from still higher volatility. By deploying a selling strategy when implied volatility is at extremes compared to past levels, we can at least attempt to minimize this risk. (See also: Options for Beginners.)

To capture the profit potential created by wild market reversals to the upside and the accompanying collapse in implied volatility from extreme highs, the one strategy that works the best is called a reverse call calendar spread. (See also: Option Spread Strategies.)

Normal calendar spreads are neutral strategies, involving selling a near-term option and buying a longer-term option, usually at the same strike price. The idea here is to have the market stay confined to a range so that the near-term option, which has a higher theta (the rate of time-value decay), will lose value more quickly than the long-term option. Typically, the spread is written for a debit (maximum risk). But another way to use calendar spreads is to reverse them—buying the near-term and selling the long-term, which works best when volatility is very high.

The reverse calendar spread is not neutral and can generate a profit if the underlying makes a huge move in either direction. The risk lies in the possibility of the underlying going nowhere, whereby the short-term option loses time value more quickly than the long-term option, which leads to a widening of the spread—exactly what is desired by the neutral calendar spreader. Having covered the concept of a normal and reverse calendar spread, let's apply the latter to S&P call options.

At volatile market bottoms, the underlying is least likely to remain stationary over the near term, which is an environment in which reverse calendar spreads work well; furthermore, there is a lot of implied volatility to sell, which, as mentioned above, adds profit potential. The details of our hypothetical trade are presented in Figure 1 below.

Figure 1: Theoretical prices with the S&P 500 trading at 850 with 61 days to near-term expiration of the October 850 call. The trade is constructed using S&P 500 call options on futures. Initial SPAN margin requirement is $935.

Assuming Dec S&P 500 futures are trading at 850 after what we determine is a capitulation day sell-off, we would buy one 850 Oct call for 56 points in premium (-$14,000) and simultaneously sell one 850 Dec call for 79.20 points in premium ($19,800), which leaves a net credit of $5,800 before any commission or fees. A reliable broker who can place a limit order using a limit price on the spread should enter this order. The plan of a reverse calendar call spread is to close the position well ahead of expiration of the near-term option (Oct expiry). For this example, we will look at profit/loss while assuming that we hold the position 31 days after entering it, exactly 30 days before expiration of the Oct 850 call option in our spread.

Should the position be held open until the expiration of the shorter-term option, the maximum loss for this trade would be slightly more than $7,500. To keep potential losses limited, however, the trader should close out this trade no less than a month before expiration of the near-term option. If, for instance, this position is held no more than 31 days, maximum losses would be limited to $1,524, provided there is no change in implied volatility levels and Dec S&P futures don't trade lower than 550. Maximum profit is meanwhile limited to $5,286 if the underlying S&P futures rise substantially to 1050 or above.

To get a better idea of the potential of our reverse call spread, see Figure 2, below, which contains the profit and loss levels within a range of prices from 550 to 1,150 of the underlying Dec S&P futures. (Again we are assuming that we are 31 days into the trade.) In column 1, the losses rise to $974 if the S&P is at 550, so downside risk is limited should the market bottom turn out to be false. Note that there is a small profit potential on the downside at near-term expiry if the underlying futures drop far enough.

Upside potential, meanwhile, is significant, especially given the potential for a drop in volatility, which we show in Columns 2 (5% drop) and 3 (10% drop).

Figure 2: Profit levels given different levels of implied volatility and levels of December S&P futures 31 days into our trade. IV represents implied volatility of the options trading on the December S&P 500 futures contract.

If, for example, the Dec S&P futures run up to 950 with no change in volatility, the position would show a profit of $1,701. If, however, there is an associated 5% drop in implied volatility with this rally, the profit would increase to $2,851. Finally, if we factor a 10% drop in volatility into the same 100-point rally in the December futures, profit would increase to $4,001. Given that the trade requires just $935 in initial margin, the percentage return on capital is quite large: 182%, 305% and 428% respectively.

Should, on the other hand, volatility increase, which might happen from continued decline of the underlying futures, the losses of different time intervals outlined above could be significantly higher. While the reverse calendar spread may or may not be profitable, it may not be suitable to all investors.

A reverse calendar spreads offers an excellent low-risk (provided you close the position before expiration of the shorter-term option) trading setup that has profit potential in both directions. This strategy, however, profits most from a market that is moving fast to the upside associated with collapsing implied volatility. The ideal time for deploying reverse call calendar spreads is, therefore, at or just following stock market capitulation, when huge moves of the underlying often occur rather quickly. Finally, the strategy requires very little upfront capital, which makes it attractive to traders with smaller accounts.