It seems like yesterday when I was attempting to do some last minute studying for an Environmental Economics test but could not concentrate, because I was very distracted by the nightly news… Yes it was the Sunday night that Lehman Brothers expected to file bankruptcy the following morning, and Merrill Lynch was acquired by Bank of America (BAC). I remember thinking how will this affect the market over the next day, week, month, year, decade, etc…, and will I ever get the job of my dreams on Wall Street (which I am still looking for)?

I am sure I’m not alone when I say, I never expected it to start the chaos it did on Wall Street. Luckily at the time I was very hedged, not because of my expectation for the entire banking industry to nearly collapse, but because I figured the high price of oil would slowly strangle the consumer and could cause a recession. I expected to see the market sell off causing the Volatility Index (VIX) to increase, so as a hedge I purchased out of the money October 30 strike VIX options for $25 per option contract, while the VIX traded below 20 in August. I never expected less than a month later my VIX options would increase more than 30 fold, but they did and I sold half of them while the VIX traded near 32. Selling half of my options resulted in a huge profit, and I couldn’t lose my initial investment, so I decided to keep my remaining VIX options until expiration or sell them into strength. Over the next month I sold many of my VIX options for huge premiums helping to keep my entire portfolio profitable, and actually sold my final contracts the day before VIX expiration on October 14, 2008 for more than a 15,000% gain ($3860 per VIX contract), which if I let the options expire and settle for cash the following day (or traded them mid day) would have been even more profitable.

I believe the market will sell off this fall, not because we are approaching the one year anniversary of that “study free” Sunday night, but because I believe we are too overbought. I believe so much as a 5% correction will cause the VIX to spike, but VIX options are very expensive due to this speculation and due to the implied volatility being so high. Even far out of the money VIX options seem expensive (mainly because VIX above previously unheard of levels is now known to be possible). Not to mention if the market continues to rally, VIX options would most likely expire worthless. So, I will take a different (less risky in my opinion) approach to capture a large market sell off, while also being able to profit from a continued market rally.

Examining the mean for the 25 Delta Call and 25 Delta put on three very active index ETF’s we can spot which one is trading for the cheapest premium based on volatility.

  • PowerShares QQQ NASDAQ ETF (QQQQ) is the highest with the current mean at 23.40%
  • SPDR Trust S&P 500 ETF (SPY) is the second highest with current mean at 22.99%
  • Diamonds Trust DOW ETF (DIA) is the lowest with the current mean at 20.50%

I chose to structure my option trade around the DIA as it is the cheapest based on volatility, and although the DOW is less volatile, if a significant move occurs in the market the DOW is sure to track closely to the other major indices give or take a few basis points. The trade outlined below requires the knowledge of stock options. To become more familiar with stock options check out my stock options trading E-Books here.

The Trade:

I opened a delta neutral strangle position for the October Dow Diamonds ETF (DIA). As the stock crossed 95.50 Friday, I purchased October 94 put options (Delta -0.429) and October 97 call options (Delta 0.419). I opened this position for $440 per option contract, and if the Dow Jones Industrial Average moves by greater than 5% in either direction over the next 46 calendar days this position will likely result in a profit. Note that if the market moves sideways and the DIA ETF expires between the two strike prices indicated, the position will result in the maximum loss of 100% of the premium paid (in my case, $440 per option contract).

This strategy should only be considered if one believes the market will experience a great move (either up or down), and should never be considered if a sideways move is to come. I believe the market will correct to the downside by 7%-10% before going higher into the year end, therefore I am long this option strangle for October. The optimal case for opening a long strangle option strategy like this would be a sell off, this is because as a sell off occurs, volatility increases [historically], causing option premiums to be priced even higher (all other things equal). Technically if volatility increases sharply without the market moving too much in one direction or another anytime soon, this strangle could also become profitable, but that is very unlikely and I am not opening it for that reason.

If profitable I will look to close out of 25%-50% of my strangles Thursday before the unemployment numbers are released Friday morning. Although the contracts don’t expire in September, it should cause increased volatility levels on the underlying, pricing these contracts slightly higher. If I can take a profit before the unemployment rate for August is released, I will do so and purchase them back on decreased volatility levels.

The ideas outlined above involve the use of stock options. The reason option volumes have surged in the last 5 years is because they are a great way to hedge your portfolio as well as create income off of your shares (see option volume chart).

These are just examples and are not recommendations to buy or sell any security; if you’re more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

Disclosure: Long DIA October 94 Put/97 Call Strangle, VIX October 30 Calls

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