We have just completed two of the most volatile weeks for the equity markets in some time. Volatility is usually associated with downside moves and that is how things started, but in two weeks we managed to experience a complete rebound from a drop that had market pundits talking about an emergency rate cut.
Buying on weakness, especially when there seems to be panic associated with that weakness, can be a difficult trade. From executing the trade to sticking with it if the market continues to drop, buying in the face of a dramatic downside move. However, having a defined outcome through using options to take a long position in the market offers a little peace of mind, making it easier to execute and persevere when the worst-case outcome is known.
Now that things have calmed down, at least for the moment, we dug through the tape to find some successful trades from early August that benefited from buying with the Nasdaq-100 (NDX) 15% below where it was less than a month before.
One NDX trade we found had defined risk and reward, but still is not for the faint of heart. On Monday August 5, with NDX at 18057, a trader sold 150 NDX Aug 16th 18000 Puts for 405.00 buying 150 NDX Aug 16th 16500 Puts for 89.50 resulting in a net credit of 315.50.
The low for the day on August 5 had occurred before this trade, but NDX did dip below the short 18000 put strike each of the following three days before remaining solidly above 18000 through AM expiration on August 16. It took a few days for NDX to start to move higher and a trade buying and ETF or future may have been more difficult to stick with than this bull spread that has a defined loss in place.
Another trade from August 5 focused on a much shorter time frame, one day. Very late in the trading day on August 5 a trader sold the NDX Aug 6th 17700 Put for 79.70 and purchased the NDX Aug 6th 17400 Put for 32.90 taking in a credit of 46.80. This trade was executed with NDX at 17895. The payoff on the close the following day appears below.
The following day, NDX closed at 18078, much higher than the short put strike of 17700. During the trading day, the NDX low was 17858, over 150 points higher than the short strike, so this trade was never in much danger.
A final trade that caught our attention used XND options expiring on August 16th. As a reminder, XND is 1/100th the size of NDX, a more appropriate size for many traders. With XND at 179.00 a trader came into the market buying the XND Aug 16th 178 Call for 5.58 while selling the XND Aug 16th 185 Call for 2.08 resulting in a net cost of 3.50 which is also the maximum potential loss for this trade.
The risk and reward for this XND bull call spread is 3.50. This trade did need XND to rise to 181.50 just to break even and then realized the maximum profit with XND over 185 which was not an issue as the NDX and by association XND moved much higher last week.
As noted, stepping in front of a downtrend can be a difficult trade to execute and stick with. When the market is moving quickly in either direction resulting in a trader looking to execute a counter trend trade (selling an up move, buying a down move) the option market offers the ability to initiate a position with defined downside risk. Knowing the worst case scenario allows a trader the ability to stick with a trade unlike a trade that may result in an unknown substantial loss.
