by Tyler Craig | September 26, 2013 6:00 am
With the market pullback going on its fifth day, dip buyers are getting antsy.
And they should be.
The relentless rise in the S&P 500 — and subsequently, the SPDR S&P 500 ETF (SPY) — has trained investors that purchasing every dip is the sure-fire way to profit. Indeed, by the time the final stages of every bull market roll around, virtually everyone is praising the virtues of dip buying. This year, the aggressiveness of buyers ended every previous losing streak before we ever reached the fifth day.
With the current downturn running a bit long in the tooth, investors are left to wonder whether a correction is brewing … or whether bulls merely need an extra day or two before staging their next assault.
I suspect it’s the latter.
With the best quarter of the year ready to kick off and economically sensitive sectors — from industrials to basic materials to small caps — still leading, the bullish case remains well-intact. Sure, the current pullback could extend to a sixth or seventh day, but the easier bet here is still on a continuation of the SPY uptrend, not a reversal.
The flexibility of the options market allows us to structure some pretty high-probability plays going into next month. Selling put vertical spreads in particular offers a healthy margin of error and a respectable return if the market stays aloft.
If you’re willing to bet the prior weekly support level in SPY around $163 holds firm, consider selling the Nov 163-158 put spread for 70 cents. The max reward is limited to the initial 70 cents credit and will be captured if the spread remains out-of-the-money. As with all vertical credit spreads, the max risk on this SPY options trade is limited to the distance between strikes minus the credit, or $4.30.
Keep in mind, however, that the max risk assumes a trader holds all the way to expiration and allows the stock to fall beneath the lower-strike put ($158 in this case). To reduce the capital at risk, you could exit the position if SPY falls beneath the higher-strike put ($163), which is also key support on the weekly chart. The estimated loss using a risk graph is approximately $100.
In timing the entry, consider waiting for confirmation that the current pullback is ending and a new upswing is beginning. Waiting for the SPY to trade above the prior day’s high (or at least intraday resistance) is advisable.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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