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As we progress as option traders, one of the things we learn is to fit the trade to the market. Often as new traders, we want to will the market to our trade and this just doesn’t result in profits. The market goes through different cycles and we need to let these cycles tell us what strategies are most viable at the time. For example, in the current market environment, implied volatilities on options have become inexpensive. Of course, this isn’t true for every stock, but in general, options are relatively cheap right now. This is because fear is decreasing and traders aren’t expecting any large moves in stocks in the near-term. So, how do we choose a strategy that fits this market environment?

First, since options are inexpensive, we would want to look at debit strategies. This is because implied volatility [IV] tends to be mean reverting. In other words, IV tends to move back to its average from extremes. Since IV is relatively low right now, the odds are it will increase in the months to come. This tells us that we have an advantage when buying options. Now that we have determined where IV is, we need to determine market direction.

Each stock will be different, but, overall, we can gauge the direction of the market to help us choose the appropriate strategy. For example, stocks have been in an uptrend these last few months, but there are signs this might not continue. For one, the CBOE Market Volatility Index ($VIX) is sitting just above a key support level at 20. This point has been where the stock market has formed market tops in the past. So, we can look for stocks that might turn around and head lower.

One way to pinpoint stocks to enter option strategies on is to look at trendlines. For example, look at the chart of Gentex Corp (GNTX) below to see how trendlines have been a great way to predict future movement.

Figure 1: Chart of GNTX with Trendlines

Notice how the breaks of these trendlines preceded sharp moves in the stock. We want to use this type of break to find good bear put spread candidates as well. Once we have found a stock in a nice uptrend, we then want to check the options to see if they are priced right for a bear put spread.

Normally, we want to see at least a 2-to-1 reward-to-risk ratio for a debit spread. For example, it we are looking at a five point spread then we don’t want to pay more than about $1.70 to enter the trade. For a five-point spread, we would have a max reward of $3.30 if it cost $1.70 to enter.

Once we find a stock and options that fit our criteria, then we want to place the trade into Platinum. Below is a risk graph for a bear put spread. Notice how the space in which a profit is achieved is much larger than the space where a loss is incurred. This shows us that the reward to risk is higher. In fact, this risk graph has just slightly better than a 2-to-1 reward-to-risk ratio.

Figure 2: Risk Graph for Bear Put Spread

By looking at the various colored lines, we can see where the stock has to move, given no change in IV, to achieve certain profits. This can give us an idea of where we might possibly look to sell to achieve a double. Most the time, our goal with a debit spread is to double our money. Therefore, if we pay $1.55 to enter a trade, then we would like to see at least a price of $3.10 to close it. However, if trading more than one contract, we can sell half our position at a double, guaranteeing us no losses, and then we can hold the other half for profits. In essence, we are playing with the houses money. If the total trade equals 80 percent of the max profit, then we normally exit the trade.

Bear put spreads can offer nice profits, but take away much of the risk in buying straight puts. However, the reward is obviously less with a spread, but we need to weigh the rewards against the risks to see which strategy works best. The nice thing about a spread is that if the stock moves against us, our losses are much lower, offering us a degree of protection.

During the next week, search the universe of optionable stocks and try to find the ones that meet our criteria for a bear put spread. I will do the same and next week we will choose a stock and track it using a mock trade. If you find one you particularly like, let me know on my forum and we just might use it as our example.


Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
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