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In case you just came back out from being in a coma last week, first off, “welcome back," and secondly, “hey, how about that stock market?" As the market came apart and plunged in the past month or so, I have been looking for some sign of a bottom based on certain potential catalysts. Chief among these were:

1) A decline in the price of crude oil
2) A spike in the VIX Index
3) A double bottom for some of the major stock market indexes.

Last week we hit all three.

On Tuesday, President Bush repealed the ban on offshore drilling, creating the prospect that the U.S. will get more oil on its own, thus – in theory, anyway – creating more supply and reducing our dependence on foreign oil. The reaction of the markets was swift. As you can see in Chart 1, crude oil reversed hard to the downside after last week’s announcement. For the stock market – which had been falling hard in the face of steady gains in crude oil – the reaction was immediate and bullish.

Chart 1 – Crude Oil finally breaks
(click here for larger view)

In Chart 2 you can see that the VIX Index (in the lower clip) finally did “spike” enough to suggest that a bit of fear was beginning to build amongst previously complacent investors.

Chart 2 – VIX finally “spikes”
(click here for larger view)

Lastly, the Nasdaq 100 and the Russell 2000 managed to successfully test their previous 2008 lows without breaking through to the downside. As these indexes have been stronger than the Dow and S&P 500, this successful test was another potentially bullish indication. In fact, the Russell 2000 has formed a triple bottom, which among technical patterns often offers a meaningful base of support.

Chart 3 – Nasdaq 100 and Russell 2000 hold above 2008 lows

So does this mean that we have seen “the bottom," and that happy days are here again? Not necessarily. However, given the extremely oversold levels reached by many indicators in the most recent fortnight, these developments do act as something of a beacon of potentially better days ahead.

One Way to Play a Bounce

For a trader with his “finger on the pulse” of the market, last week’s action offered an instructive lesson in “taking what the market gives you." Lots of people routinely feel the urge to “pick a bottom” or “pick a top” in the market. This is just human nature. The main problems associated with trying to pick a bottom in anything are:

1) It is an extremely difficult thing to do successfully.

2) Lots of individuals carry around negative emotional baggage after an unsuccessful (and in hindsight, clearly foolish) attempt to pick a bottom.

This is why options can be quite useful to traders who feel that their timing is right and want to make an attempt at bottom picking. By utilizing certain option strategies an alert trader can take advantage of certain opportunities without assuming an unlimited amount of risk. In the worst case scenario, this can serve to limit the amount of fallout and psychological baggage that can accompany an unsuccessful attempt to pick a bottom.

Let’s go back to 7/16/08, the day after President Bush announced the repeal of the offshore drilling ban. Crude oil sold off $6 a barrel and the Dow rallied 276 points. A trader tracking the factors I mentioned earlier might assume that at lease a short-term bottom was in place. So the next question is “how to play the impending rally?”  The possibilities are almost endless but one strategy that can be extremely useful in an oversold market – particularly when implied volatilities are running on the high side – is the bull put spread. This strategy simply involves selling a particular put option – usually one that has a strike price below the current market price, and is therefore out-of-the-money – and simultaneously buying another put option with a lower strike price.

For the purpose of example, let’s use Optionetics Platinum software to find bull put spread opportunities among the various stock indexes. We first create a list of those stock indexes that held above have made a double bottom (See Chart 4).

Chart 4 – Stock Indexes that held above 2008 lows

Next we will go to Smart Search, select our new list to scan and click “Bull Put Credit."

Chart 5 – Platinum Smart Search

Once we get the output there are couple of steps I like to take (For the record, these steps are someone subjective, not always followed to the letter and not intended to represent a “be all, end all” method of identifying winning trades. Alright, with the backside sufficiently covered, let’s proceed).

1) First I click on the heading that reads “Max. Profit/Risk.," to rank trades by reward-to-risk ratio.

2) Next in the left hand column I checkmark the top 20 trades that have more than 1 day left until expiration (this eliminates the July options), hen click “Show Checked” to leave only those 20 trades in the list.

3) Lastly, once again click “Max. Profit/Risk” heading. Then starting from the top of the list, find the first trade with at least a 66% (i.e., 2 out of 3) probability of generating a profit.

Chart 6 – Bull Put Spreads sorted by Maximum Profit/Risk

The trade that meets these criteria is the first one on the list. This trade involves selling the August RUT 670 put and buying the August RUT 660 put for a credit of $290. The risk curves for this trade appear in Chart 7.

Chart 7 – Risk Curves for RUT August 670/660 bull put spread

As you can see, if RUT rallies or remains relatively unchanged for the next month this trade will show a profit. So is this trade a sure thing?  Hardly. As always, the most important thing to do before putting on any trade is to identify the risks involved. For this trade there are two things to keep in mind.

1) The trade has profit potential of $290 but downside risk of $710.

2) The breakeven point for this trade (667.10) is above the 2008 low for the RUT index. What this means is that if RUT goes back down and retests the 2008 low between now and August expiration a trader in this position might be required to act in order to minimize risk and/or to cut a loss.

One possibility here would be to move down in strike price in order to push the breakeven point for the trade below the 2008 low for RUT. The tradeoff is that a lower strike price bear put spread would have a less favorable reward-to-risk ratio.

Summary

As always, there is no free lunch in trading. The purpose of this example is simply to give traders some insight into just one more way to:

1) Take what the market gives you.

2) Use options to enter into a high probability trade with limited risk.

To search for previous articles written by Jay Kaeppel, please click here.


Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site

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