Best Ways to Maximize Increased Market Volatility

COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!

Perhaps a Turnaround in the S&P

Last month for the first time in thirteen years the insiders of US registered companies bought more shares than they sold. January 1995, the last time this occurred the S&P rallied over 34% during the year. Taking advantage of the S&P moving down 6.1% last month inside purchases on the New York Stock Exchange by senior executives and directors totaled $683 million while sales were only $475 million. No doubt with a commitment like this, insiders believe the market is close to forming a bottom.

The Federal Reserve continues to provide much needed liquidity. Federal funds have been chopped by 125 basis points. The language of the Fed suggests they are open to allowing for a further cut in the March meeting. The Bank of England meets this week and is anticipated to cut its base rate by 25 basis points to 5.25%. If all of the bad news is out regarding sub-prime and the interest rates continue to be lowered it makes for a corporate friendly environment.

As we continue to have the world’s two most populated countries, India and China, experience greater personnel wealth, demand for more durable goods will continue to set records. This hunger for a better standard of living is fed by a weak dollar and a growing demand of American and European goods.

A 12% drop in the price of crude oil (from a high of over $100 a barrel to the current level of under $88) may also signal an approaching bottom in the world’s stock markets. Cheaper crude oil means cheaper transportation cost for goods and raw materials. Along with cheaper costs comes higher corporate profit margins.

From the current level a limited risk way of trading the S&P 500 would be with an April credit spread. By selling an April 1150 put and buying an April 1125 put prior to any commissions or fees the premium collected would be $750 yet the margin on the position would only be $800. If the market which is currently at 1350 basis the June contract stays above 1150 you keep the premium you collected. This is a return of 90% on margin in a total of 73 days. Yet your risk, because you are not naked but covered with the 1125 you own is, $6,250 minus the $750 collected prior to any commissions or fees. The recent volatility and drop of the market allows you to take advantage of over-valued positions. The spread enables the seller to establish a position that is almost 15% out of the money. On a rally an out of the money call spread could be sold for April with a minimal, if any, increase in margin while receiving more premium.

Perhaps a Turnaround in the Grains

Wheat is currently trading at $10.33 a bushel with the March contract up the daily limit of 30 cents. Although wheat exports are currently 53% above a year ago and out pacing the USDA estimate that exports this year will be 29.5% higher than those of last year, exports have begun to slow. Wheat export inspections have topped out the end of last summer and continue to show a marked decline. The sentiment is extremely bullish, perhaps too bullish. The latest Commodity Futures Trading Commission figures show that index funds are currently long 29 thousand contracts of wheat and short only 20 future contracts. Yes 20 not 20 thousand! Non commercials are long a total of 33 thousand while being only short 5.2 thousand contracts. When too many people lean on one side of the boat it has a tendency to tip. Excluding new investors to fuel a continued rise in the market, it becomes difficult to sustain a rally for any time. Those that are bearish must be convinced to buy back their shorts and even asked to replace them with longs.

On the other hand, if the market starts to correct and the longs sell either by choice or from receiving a margin call things could quickly turn around. To lessen their positions the longs would have to sell. Selling of this magnitude may cause more and more liquidation.

A great way to take advantage of a market that may be experiencing a blow off top or running out of gas is the following:

May wheat is currently trading at $10.49 per bushel. Trying to predict tops or bottoms in such a market is sheer guess work. Instead let’s try and predict where the market is not going. Options for May wheat expire in 78 days. Establishing a credit spread on the call side allows you to capture over-valued premium. By selling the $13.00 call and buying the $13.50 call the premium collected will be $500 per spread excluding commissions and fees. The risk associated with this trade is the difference between the strike prices $13.50 – $13.00 = .50 times the contract size of 5000 bushels = $2,500 minus the amount collected (roughly $500).

Another way of attacking the market involving more profit potential as well as more risk is the ratio write. By purchasing one $13.00 call and selling four $14.00 calls in the May wheat you can collect approximately $1,200 before any commissions or fees. The ideal scenario is at expiration the market closes just under $14.00. The call you own is worth about $5,000 and the calls you sold that are out of the money are worthless. The trade gets closed out with you having initially collected $1,200 and at expiration $5,000 for a maximum gain of $6,200. However, in most cases all options will expire worthless and just the initial premium is retained.

In essence the ratio involves one long bull call spread (long the $13.00 call and short the $14.00 call) and three naked calls. Unlike the credit spread your risk is not predetermined.

Even though wheat has never traded above $11.00 the risk is unlimited. In case of an adverse sustained move stops can be placed on the options, the position could be rolled out, trailing GTC future stops can be placed or the position can be exited but theoretically the risk remains unlimited.

The options are so overvalued that even a 35% increase from the current level is not enough for the option buyer to make money. That is the beauty of selling options.

Mr. Ed Carr graduated from Allegheny College with a Bachelor of Science in Economics. He continued his education by obtaining a Masters in Business Administration in Finance from Fairleigh Dickinson University. His initial career foray was as an account executive of a large commodities brokerage firm. In five years he was ranked as a top producer and was promoted to management. Shortly thereafter he was recruited by a major brokerage firm and became their Vice President.

In 1987 he put his experience to use and founded Carr Investments Incorporated. Carr Investments had professionally handled thousands of clients worldwide for ten years. In 1998 the assets of Carr Investments were acquired by Trader's Edge Inc. Mr. Carr took over the role of President and Jonathan Lubow as Vice President.

His vast experience has enabled him to market four unique ways of trading options that have been utilized by many firms, as well as individuals. Mr. Carr has appeared as a guest on several investment shows and given numerous seminars and lectures to professional investors, corporations and individuals throughout North and South America. Mr. Carr has been married for over twenty-five years, has four children and resides in Morris County New Jersey.

Ed is also a contributor to Optionsscholar.

COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!