Is it Time to Change Your Strategy?

Well, March was an eventful month. We had the world's third-biggest economy suffer a massive earthquake and tsunami followed by an ongoing nuclear emergency. If that was not enough, the massive unrest in the Middle East has continued to spread. NATO is bombing the Libyan Army currently.

Finally, the problem children of Europe are seeing the CDS on their debt spike to new highs. We got an initial sell-off, but since Japan has seemed to stabilize, the SPDR S&P 500 ETF (SPY) is now higher than it was on March 11 – the day of the earthquake, and within spitting distance of its February highs. Likewise, after a quick spike in the CBOE Market Volatility Index (VIX), we are now back to a VIX reading around 18.

What does it all mean for your trading strategies? First of all, since September of 2010, we have seen a strong rally in the stock market. Chalk it up to people rolling out of bonds, bringing in cash that was previously on the sidelines, chasing beta, or whatever other catchphrase you want – the market has been stronger. For it to shrug off what happened in March is pretty impressive.

Should you believe that recent market trends will continue and considering the convergence of the VIX back below 20 (and the things going on around the globe), it might be time to at least evaluate some strategies that have a long volatility bias (or ones that could hedge against a move against your positions).

Examples of these kinds of strategies include:

Stock replacement with long calls. Buying in-the-money calls while volatility is at this level gives you a built-in stop loss on your position. You know going into a long call trade that the maximum loss (before commissions) is capped at the premium paid.

Also, in the case of a massive sell-off in the market, implied volatility may rise, so you could theoretically lose less on the calls if they are longer-dated than you anticipated, since the extrinsic value could be relatively higher from a jump in volatility.

Collaring long stock: If you own a stock, you could sell an upside call and buy the downside put. This limits your upside, but hedges your downside. For example, with Netflix (NFLX) trading at $236, you could sell the September $260 calls for about $21 and simultaneously buy the September $210 puts for about $20 (the markets are wide in NFLX, so it is hard to pinpoint final fill prices).*

In this trade, if your loss is stopped out below $211 (you collected a dollar on the initial trade) and the put becomes in-the-money at $210. If the stock is between $236 and $260 at September expiration, you make money on your stock, and your options expire worthless (except you pocket that dollar). If the stock is above $260 when the options expire, it will be as if you sold the stock at $261. You will give up any further upside in the stock above this point.

Buying at-the-money (ATM) calls to sell out-of-the-money calls, rather than buying in-the-money call spreads. You will have less premium at risk in case of a big selloff.

Buying protective puts against your portfolio. There are two ways to do this: first, you could buy a put against every stock that you own. This can get expensive, even at lower volatility levels, but if you are worried about a selloff, now might be a good time to look at some hedging opportunities.

For those of you with very diversified portfolios (or diversified within one industry), you could buy puts on the ETF of your choice to hedge against a big market sell-off, even if you own individual stocks. There is obvious risk to this strategy. If, for instance, the stock you own tumbles because of bad earnings but the broad market rallies, you actually would lose money on both trades.

However, if your portfolio consisted of 20 stocks of equal position values that are among the top 200 names of the S&P 500, there is a very good chance your portfolio is highly correlated to the SPY. If that is the case, you could buy some SPY puts at a lower volatility than the individual puts to just hedge some market risk.

For those of you who are short the market, you can do similar strategies in the opposite way. For example, for a stock-replacement strategy, you could replace short stock with in-the-money puts.

My general point is that just trading one strategy, regardless of the overall market conditions, may not be the best way to approach your portfolio. You can still do bullish trades that have different characteristics.

Also, for those of you who are Iron Condor sellers: please check what kind of premiums you are taking in right now and make sure it is worth the risk you are assuming. Between the market risk and the earnings risk looming in about a week, it may be time to re-assess.

*Prices are as of Thursday afternoon.

The above information is provided by OptionsHouse, LLC (“OptionsHouse”) for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.

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