By Andrew Giovinazzi
With earnings season getting to the midway point, most of the numbers have been OK. The market has not taken off, but it has not fallen out of bed either. We are in what I call a low-volatility environment, and the U.S. equity market has not seen that since last January when it climbed out of the second or third European Crisis. There have been so many I cannot remember anymore.
Mostly, a low-volatility environment is due to the nature of the underlying securities . The market is not really going anywhere fast today. This does not mean realized volatility cannot pick up, but for now it is relatively muted. That calls for different kinds of positions. The S&P 500 at a 4% 10-day realized volatility is a different animal than the SPX at a 20% realized volatility.
What I do not want is net-short volatility exposure at this level. I like the idea of collecting time decay when I sell options, but the lower long-term volatility levels are not a sale yet. This is a question of current conditions and fitting an option trade to them.
If you follow this column at all you will notice the last five trading ideas have worked out nicely. For most option trades, you need a bailout of sorts if things go wrong. The biggest impediment to trading options is running out of time with the position before the market catches up to the plan. A way to get around this is a variation of a time spread. We used this in the Financials ETF (XLF) and Apollo Group (APOL) trades so far in 2013. Not much really has changed except now we have a small uptick in shorter term IV, so let's use it.
The best financial innovation in 2012 was the launch of the laddered weekly products that have expirations four weeks out, every week, on some of the more active names. What this expiration cycle does is create new opportunities for investors who like to write options against positions but don't want the extended hold time of a standard expiration cycle. The trade example I am going to show to illustrate the advantages of these new products uses Ford (NYS:F) and could not be executed until recently because the products did not exist.
This example is relatively simple. Earnings came out today, and the company is still doing well but sees headwinds in Europe. The nice thing about the market is it usually discounts the current news that day, so F is cheaper because of it. Ford is down around .75 (as on Jan. 29, 2013). I still think it is a cheap stock, but it could get cheaper in the short term, so here is the trade:
Sell the Ford Feb 8 Weekly 12.5 put for .08
Buy the Ford Jun 12 put for .48
Keep the ratio 1:1, and the trading plan is simple. If Ford gets weaker, no problem, simply roll out of weekly put into the next strike down. Remember the put will decay rapidly and even if Ford trades 12.5, the position will still win and the idea would be to sell the next weekly put one strike lower.
Continue on until your long June put is financed by selling puts just out of the money every week.
There are a few other options on this, but that is the general idea. The weeklys will provide the time decay flexibility the position requires and the investor does not have to get short volatility to do it. The key here is the risk is very small to get started and that is the best way to learn to invest with options.