This week’s tech wreck provides a tantalizing teaching opportunity. Let me say at the outset that this is merely an example, and is not a trade recommendation. It’s time you learned how seasoned option aficionados use oversold markets and high implied volatility to sell pumped-up premiums. We’ll also sprinkle in the scaling-in technique to guarantee you depart today’s post with pleasure and enlightenment.
The tech-heavy Nasdaq suffered the brunt of sellers’ wrath in recent days. Heavy hitters from Amazon and Netflix to Salesforce and Square were heavily hit. While it’s a terrible trial for existing bulls, spectators now have a fantastic opportunity to enter the fray.
When uptrending stocks suffer slippery retreats, it makes you wonder. Was that the top? Is this the beginning of something more ominous? Is a bear market afoot? The answer to all three questions is “probably not!” All but the very last dip in an uptrend are bought. Most selloffs are buying opportunities leading to higher prices. Let’s treat the current episode like all of its predecessors – a pullback to be pounced on.
The other dynamic demanding our attention is implied volatility. In options boot camp your drill instructor beat a single sentence into your skull.
“Sell options when implied volatility is high!”
Are you ready to apply your training, to practice what was preached? Predictably, this week’s descent has seen scaredy-cat behavior. Like spooked children, the residents of the Street ran headlong into the options market to scoop up protection. Naturally, the demand uptick has driven option premiums to the moon. Just look at the Nasdaq’s Volatility Index:
The implied volatility rank for AMZN, NFLX, CRM, and SQ has risen alongside the Index. To capitalize on the pumped-up premiums and the potential for a snap-back rally in the week’s ahead, let’s sell a bull put spread. We’ll use CRM to illustrate.
At $112, the stock has already fallen 13% off its highs. Suppose we’re willing to bet that buyers will step-in well before the stock drops to $100. We could sell the May $100/$95 bull put spread for 50 cents. Think of it this way: by selling the spread we’re betting this 12% correction won’t grow into a hold-me-mommy 22% crash. At least for the next 50 days.
If you’re wondering why we’re able to go so far out-of-the-money and still garner a 10% return for a credit spread, wonder no longer. This is what happens when fear runs amok, and traders go cuckoo for put puffs.
As for the scaling-in concept. If you wanted to increase your odds further (and if you’re willing to sell multiple contracts), you could sell one bull put spread now for 50 cents and wait to sell the other one at 75 cents or $1.00. That way, if CRM falls further before finally rebounding you will be able to enter the second half of your position at a better credit. This increases your overall profit potential while widening your profit range at expiration.
Got it?
