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Let’s talk this week about trading. More specifically let’s talk about trading in chaotic markets. Now there is a scary prospect. Because let''s face it, a lot of money can be lost very quickly if you get on the wrong side of things when the markets are volatile. That being said let me make two comments:

• If you are a trader it is your “responsibility” to be looking for opportunities in a volatile market because – while risk is high – this is when the potential to make a lot of money very quickly exists.
• If you risk more than a small portion of your capital on new trades in volatile markets and/or if you do not manage the risk on those trades, then you are simply not a very good trader.

Regarding that second point, you may be good at timing buy and sell points. Nevertheless, if you are taking large risks and/or failing to protect yourself, you are, nevertheless, not a good trader, because the real key to successful trading is to obtain the greatest possible reward-to-risk tradeoff. Big returns off of small risks lead to long-term profitability. Big returns accompanied by large risks invariably ultimately lead to large losses.

In football a popular phrase among old-school type coaches is “take what the defense gives you” (with the exception of the Bears whose offensive philosophy has long been “is it time to punt yet?”). There is a trading corollary which basically states “take what the market gives you." Remember that one man’s panic is another man’s opportunity. Let’s look at one example.

Apple

To say that the iPod has been and remains a popular item would be a minor understatement. In fact if you don’t believe me ask someone who wears one. If you can get them to take it off. With some people I fear you may have to have them surgically removed. (For the record they are not as cool as the jPod I invented a while back, but I digress). Still, Apple is no more immune to the dreaded “business cycle” than anyone else. As you can see in Chart 1, after peaking north of $200 last December, AAPL has since plummeted to 115, rallied back to 192 and then collapsed to as low as 100.59 a share. Volatility anyone? 

Chart 1 – AAPL plummets
(click here for larger view) 

Are there opportunities here? Of course, but one thing to keep in mind is that implied option volatility is through the roof. As you can see in Chart 2, the implied volatility for 30-60 day AAPL options has spent the bulk of the time between 30% and 50%. By 10/3/08 implied volatility shot up past 90%. This indicates that option premiums are relatively huge for AAPL compared to the historic norm. This in turn suggests that selling option premium might be the best way to take advantage of this situation.

Chart 2 – AAPL Implied Volatility soars

There are many possibilities. Let’s take a look at one. The trade shown in Charts 3 and 4 is referred to as a “modified butterfly” because the strike prices are not evenly centered around the middle strike. In this case we are selling the November 90 put and buying the November 95 put and the November 70 put.

Chart 3 – AAPL October Midified Butterfly Spread

As with any trade there are pros and cons to consider. The good news for this trade is that it offers the potential to earn 56% ($1440 for a $2560 risk) in 49 trading days. With the stock at 97.40 there are 14.60 points of downside protection as the breakeven point for this trade at expiration is 82.80, which is well below the recent panic low.

Chart 4 – AAPL November Modified Butterfly Risk Curves

So what’s the bad news? The bad news is that this type of trade is not one that you can just put on and forget about. If you put this trade on and AAPL does plummet you would lose $2560 on a one-lot. So this does not necessarily fit the label of a “low-risk” trade. You need to have some type of exit in mind. For example, you might resolve to exit this trade if AAPL drops below the breakeven point of 82.80. Depending on how quickly this happened the result could range anywhere from no gain or loss to a loss of about $750.

Summary

The week after this trade was discovered the stock market collapsed. At it lowest point AAPl fell to 85.68 and this trade had an open loss of -$400. Since then AAPL has bounced up to 112, back down to 87 and as this is written is back up to 97. The trade is presently showing a small profit.

As always this example is not a trade recommendation but is simply meant to serve as an example of one way to take advantage of panic and fear and volatility and how to use it to your advantage. By employing risk management (i.e., by resolving to cut a loss if the trade’s breakeven price is violated) you basically have roughly a 2-to-1 reward-to-risk ratio with 15 points (or about 12%) of downside protection. So the important thing is not to look at this one trade and vote thumbs up or thumbs down. The idea is to get you to think in terms of looking for opportunities that most people have no idea exists.

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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