Phillip Wiegand, Optionetics.com
September 6, 2001

What a quick turn the markets decided to take this week.  Wasn’t this supposed to be the week where all the professional traders returned from their illustrious vacations to help stabilize and provide more liquidity in the market?  At least that’s what Wall Street was anticipating; isn’t it ironic that the exact opposite happened?  It seems the momentum players and “hedgies” are controlling the direction of the tape. They’ve been taking stocks down very quickly on any bit of negative news. Unfortunately, the fact is that there’s no positive news from individual companies these days.  The longer-term investor has the luxury of sitting through these rocky periods, if they are structured correctly; however, the active trader needs to use the right tools to profit in these difficult periods.  

To profit in the short run in such a turbulent market environment, let’s take a look at how momentum traders operate since they are running the show. Momentum investing is a short-term trading approach where the trader is trying to profit from large swings in a given security or the overall market.  Since many times this is purely a directional bet, this style of trading tends to be very risky and stressful.  However, the proper use of options can help to reduce the risk and still create an opportunity for a nice return on investment.  Recently, the moves have been very short and sharp, making it more difficult to exploit the moves.  

Momentum investors are more technically oriented than the value and growth guys.  They are concerned primarily with a stock’s price pattern and other technical indicators, rather than the company’s earnings, P/E ratios, or other fundamental criteria.  Specifically, they look for indications that a market is going to continue in the same direction for a certain time period.  Momentum investors like to find the primary trend of a market and trade with or against that momentum in anticipation of profiting from it.  Right now the primary trend is down with periodic ramps higher to lure in unsuspecting investors.  

This can be a very dangerous and unprofitable game if you don’t structure your positions correctly.  Since there are no indicators or systems that are 100% accurate in forecasting the future direction of a security’s price, being wrong in your short-term market assumptions is inevitable.  Fortunately, the appropriate use of options can help to overcome this inability to always be correct in timing the market. Options can also help to reduce risk when trading volatile markets.

Case Study: Mini-NASDAQ 100 ($MNX)

The MNX was created so that investors would have an investment vehicle that mirrors the Nasdaq 100 Index.  Actually, the MNX is the NASDAQ 100 ($NDX) divided by 10.  This index provides traders with the means to hedge a portfolio of technology stocks and to speculate on the overall direction of the market.  Recently, this index has not been able to break out above resistance and looks poised to continue lower in the short term.  The index is about to break the April lows and it is having trouble getting traction along with the rest of the market.  Combine this with a historically bearish season for stocks and you have a formula for some more exciting downside action.  

How can we take advantage of this situation and not get seriously hurt if the market decides to rip higher?  There are a couple of different options strategies that can be implemented; the simplest is putting on a bear call spread using shorter-term options.  This type of trade profits from a downward move in the MNX yet provides limited risk if the index reverses higher.  For example, you could buy 1 MNX Oct. 120 call and sell 1 MNX Oct 100 Call for a net credit of 18.

Trade characteristics at October expiration:

Long 1 Oct MNX 120 Call & Short 1 Oct MNX 100 Call @ Credit of 18
Maximum Risk	$200    (difference between strikes minus net credit)
Maximum Reward	$1,800 (net credit)
Breakeven	118     (short strike plus net credit)
Reward/Risk Ratio	9     (reward divided by risk)

This trade allows you to participate if this market continues lower; and it will react immediately to additional slippage in the NASDAQ 100.  However, the best characteristic about this trade is that there is not much risk exposure if the market turns higher.  The bottom line is that if your bullish trades make more than what you lose with your bearish trades when the market heads higher, then you have a good hedge.  The same is true on the downside.  There is no assignment risk before expiration due to the fact that MNX options are European style (i.e., option contracts can only be exercised on the expiration date.).  

During these turbulent times, it does not hurt to have some hedges out there that will profit from a move down in the market.  Momentum traders tend to move the markets to extreme levels so it’s nice to capture profits while extremes are being tested.  The bear call spread is just one way to profit on the downside and help to keep the grizzly from eating your lunch.

Good Luck!


Phillip Wiegand
Senior Writer & Trading Strategist
Optionetics.com ~ Your Options Education Site
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