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We at Liberty Trading watch CNBC in our office. We watch Bloomberg News. At times, we’ll switch it over to Fox Business. All quality channels, no doubt. However, as I watched CNBC  go to break earlier this week with the host’s parting words “Nobody panic,” it occurred to me that these channels tend to operate with one narrow focus in the scheme financial investments: The stock market. Particularly, the direction of the stock market. In mainstream financial media, if the stock market goes up it is “good” and if the stock market goes down, it is “bad.” The focus is on picking stocks that will, might, or should be “good” (go up) and avoiding stocks that are “bad” (go down).

If one has been tuning in lately, one may be quite convinced that times are “bad."  And this may be true, particularly if you are a mainstream stock trader trying to pick winning stocks in a bear market – or if you are simply a passive investor, watching your IRA or 401K go to (you know where).

But what if you are long commodities? Then you are enjoying one of the most spectacular bull markets of all time. What if you are a hedge fund short the S&P or the Dow? Well, then you are having a party.

The point is, there is no good or bad in investing. Only the investment you hold and, in particular, what side of it you are on.  The financial media places its focus on equity markets and their direction simply because the majority of investors buy stocks and hold them – either directly or indirectly. When stocks as a whole decline – mainstream investors suffer and the media wants to share their pain.

The problem is, most people don’t know how to invest any other way – nor do they have the time and/or inclination to learn.

There are people profiting handsomely off of declining equity prices. You can be one too, provided you are willing to invest a few minutes to learn a different way to approach the market.

For those looking for ways to get “defensive” or “protect yourself,” this article is not necessarily for you, although the strategy employed could probably serve those purposes. This is about going on the offensive – accepting the bear market in stocks and relishing it.

For those familiar with our column, our book or our portfolios, we are of course talking about selling options.  In this case, the fairly obvious strategy of selling calls on the S&P.

It is true that equity prices have declined sharply over the past few months and some traders are looking for a bottom. Good luck to them. However, even if these optimists are right, chances are that a call selling strategy will still work well. The inherent logic of selling calls (or puts for that matter) is that one does not necessarily have to be right the market’s direction to profit.

While our portfolios generally focus on selling options on commodities, we do trade the occasional index option if we feel the market is offering an opportunity. In this case, we do.

Our outlook for equities remains bearish, at least into the fourth quarter of 2008 and possibly beyond. The current credit crisis with Fannie May and Freddie Mac combined with the Iran/Israel situation has created an environment of fear, which translates into equity liquidation. Home prices are continuing to decline and oil prices are continuing to rise which should pressure the consumer and hurt earnings.

It is true that equities could reverse and rally at anytime, especially in the current oversold market and current valuation levels. However, we cannot see a scenario where stocks could put together any type of sustained, substantial move to the upside in the existing economic conditions. The problems the stock market is facing do not have a short term fix which should, at the very least, keep a cap on upside breakouts. This is a perfect scenario for selling calls.

When selling calls, one does not necessarily require the price of the S&P to keep falling. The call seller only requires that the market remain below his strike price. While a call option can be sold by itself (called selling naked), we advise selling covered positions or credit spreads in the S&P due to the favorable margin requirements and because of the substantial risk protection then offer. The example below reflects the strategy we are currently recommending to portfolios.

EXAMPLE: SELLING DECEMBER S&P CALL SPREAD

Let''s assume the investor, rather than sell a naked option, decides to sell a December S&P 1500 call. He could simply sell the call for 430 points ($1,075). If the S&P is anywhere below 1500 at option expiration, he keeps the $1,075 as profit. However, the position does expose him to some risk if the stock market suddenly rallies. Instead, the trader elects to sell the same option, except as a covered position. He goes ahead and sells the 1500 call, but then takes part of the premium collected ($1,075) and buys a 1550 call to protect or “cover” his 1500 call. In this case, the 1550 call would cost him 165 points or $412. The premium left over, or “credit” of $663 ($1075 - $412) will be his profit if both expire worthless. This is called a bear call spread. It’s a neutral to bearish position that is established using call options. If the trader was neutral to bullish, he could have used the same strategy to establish a bull put position.

Positioning in this manner accomplishes 3 things.

Firstly, in a worst-case scenario, the investor has an absolute limited risk of 50 points on the trade. In this case – were the market for some reason exceed 1500 at expiration- the profit on the long call covers all losses over the 1550 level on the short call. While this is not a desirable scenario, it does provide a worst case downside. However, there is no need for a trader to hold the position this long. The trade can be liquidated at any time the trader begins to feel uncomfortable.

Secondly, and more importantly, if the market does move against the trader’s position, the option values will tend to move together (although the 1500 call will increase slightly faster than the 1550 call). This means that even as the market moves temporarily against the position, the paper losses are only a small fraction of what they would be in a naked position. Therefore, the investor can sleep at night, even in adverse market conditions.

Thirdly, the margin on writing the covered position is substantially lower than if he were to have sold the option naked. Not only that but the return on equity invested, in most cases, becomes substantially higher. At the time of this example, the trader could have collected a net credit of $663. The margin requirement?  $1640. For the number crunchers, that’s a 40% return in about 120 days if the S&P stays below 1500. Much higher than if the trader had sold naked and posted the required margin of nearly $5000.  Of course, there is nothing to say the S&P won’t soar above 1500 in that time frame either, causing the investor a loss.

While covered option selling is not perfect for every market situation and may not be feasible in others, we have found them to be very effective in trading the S&P. While fundamental analysis is very difficult if not futile in the indexes, the distant strikes available in the S&P futures can make a little common sense analysis go a long way.

Figure 1: S&P, July 11,, 2008

Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.


James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
Questions for James and Michael? Visit the Optionetics.com Discussion Board

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