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Options Theory: 3 Ways to Play the Dip

February 18, 2021

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You wanted a market dip, and you finally got one. At least in the Russell 2000, you did. The S&P 500 is a stingy bugger and didn’t even drop half a percent on Thursday.

Lame.

To celebrate the much-needed retracement, I’m highlighting three trade examples of how one might buy the dip. These are illustrations, not recommendations.

Come to Papa, Mr. Russell

Of all the indexes, I’m most fond of the pattern beckoning in the Russell 2000 Index. It’s been on fire for months, and every pullback has been a buy. I see no reason why we shouldn’t treat the current one similarly.

We’re down three bars in a row and close to kissing the rising 20-day moving average. Importantly, volume during the dip has been minimal. No death-dealing distribution or mass exodus to be concerned with. While we need a reversal candle to trigger, prices are close enough to support to build trades now.

How about a March Bull Put Spread? You can sell the $2000/$1990 for around $1.10. It offers an 85% probability of a 12.4% return.

Biotech is a Beaut

I used the S&P Biotech ETF (XBI) as my final pick in this week’s Trade Masters. Due to Thursday’s weakness, its retracement continued for the seventh day in a row. No matter – I still like it.

Rather than sell OTM put spreads, let’s use the lower implied volatility rank of 21% as an excuse to buy a conservative bull call spread. With XBI at $156.54, suppose we bought the March $155 call while selling the March $160. The current cost of the spread is $2.50 offering a balanced risk/reward.

The max loss is $2.50 and will be forfeited if XBI sits below $155 at expiration. The max gain is $2.50 and will be captured if XBI rises above $160. Given that we were there just yesterday, this isn’t a tough ask. And yet, the potential reward is still a whopping 100%.

Sounds sexy, no?

For confirmation, you could wait until XBI takes out Thursday’s high.

MOMO has Mojo

We highlighted MOMO in today’s Halftime Report, and it’s so darn attractive; I have to mention it here. It has all the characteristics of a textbook bull retracement—uptrend with increasing momentum, light volume retreat, reversal candle, and good risk-reward.

It’s low price tag and higher implied volatility rank (50%!) make MOMO a prime naked put candidate.

Suppose we sell the March $15 put for 40 cents.

The max gain is $40 and the original margin requirement is only around $150. That translates into a potential return on investment of 27%.

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