Just before the close on Friday, we made a strongly bullish trade on our favorite underlying stock in a portfolio at Terry’s Tips. In my personal account, I bought weekly calls on this same underlying. As I write this in the pre-market on Monday, it looks like that bet could triple in value this week.
I would like to share with you the thinking behind these trades so next time this opportunity comes up (and it surely will in the near future), you might decide to take advantage of it yourself.
A Possible Great Option Trading Idea: As we have discussed recently, option prices are almost ridiculously low. The most popular measure of option prices is VIX, the so-called “fear index” which measures option prices on SPY (essentially what most people consider “the” market) is hanging out around 12. The historical mean is over 20, so this is an unprecedented low value.
When we sell calendar or diagonal spreads at Terry’s Tips, we are essentially selling options to take advantage of the short-term faster-decaying options. Rather than using stock as collateral for selling short-term options we use longer-term options because they tie up less cash.
With option prices currently so low, maybe it is a time to reverse this strategy and buy options rather than selling them. One way of doing this would be to buy a straddle (both a put and a call at the same strike price, usually at the market, hoping that the stock will make a decent move in either direction. In options lingo, you are hoping that actual volatility (IV) is greater than historical volatility.
The biggest problem with buying straddles is that you will lose on one of your purchases while you gain on the other. It takes a fairly big move in the underlying to cover the loss on your losing position before you can make a profit on the straddle.
A potentially better trade might be to guess which way the market will move in the short term, and then buy just a put or call that will make you money if you are right. The big challenge would be to find a price pattern that could help you choose which direction to bet on?
One historically consistent pattern for most market changes (the law of cycles) is that the direction of the change from one period to the next is about twice as likely to be in the same direction as it was in the previous same time period. In other words, if the stock went up last week (or month), it is more likely to go up again next week (or month).
We tested this pattern on SPY for several years, and sadly, found that it did not hold up. The chances were almost 50-50 that it would move in the opposite direction in the second period.
Maybe the pattern would work for our most popular underling, an ETP called SVXY. You might recall that we love this “stock” because it is extremely volatile and option prices are wonderfully high (great for selling). In the first 22 weeks of 2014, SVXY fluctuated by at least $3 in one direction or the other in 19 of those weeks. Maybe we could use the pattern and buy weekly either puts or calls, depending on which way the market had moved in the previous week.
Once again, the historical results did not support the law of cycles pattern. The stock was almost just as likely to move in the opposite direction as it had in the previous week. Another good idea dashed by reality.
In making this study, we discovered something interesting, however. In the first half of 2014, SVXY fell more than $3 in a single week on 5 different occasions. In 4 of the subsequent weeks, it made a significant move ($3 or more) to the upside. Buying a slightly out-of-the-money weekly call for about a dollar and a half ($150 per contract) could result in a 100% gain (or more) in the next week in 4 out of 5 weeks.
If this pattern could be counted on to continue, it would be a fantastic trading opportunity. Yes, you might lose your entire investment in the losing weeks, but if you doubled it in the winning weeks, and there were many more of them than losing weeks, you would do extremely well.
For those reasons, I bought calls on SVXY on Friday. The Jul-14 90.5 call that expires this Friday (July 18th) could have been bought for $1.30. The stock closed at $88.86. I plan to place an order to sell these calls, half at $2.60, and half at $3.90. The pre-market prices indicate that one of these orders might exercise sometime today and I will have all my money back and still own half my calls. It might be a fun week for me. We’ll see.
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