by John Kmiecik | October 10, 2013 8:18 am
Not sure what the market will do next? You’re certainly not alone. There is an options strategy for that scenario … but unfortunately, there are other factors involved — such as potentially overpriced options — that may leave that strategy a little more vulnerable to losses than usual. If you think the end of these government shenanigans is near, here is a trade idea on the SPDR Dow Jones Industrial Average ETF (DIA) to consider.
The trade: Sell the October 144/146 Put Credit Spread (selling the October 146 put and buying the October 144 put) for 35 cents or better.
The strategy: The maximum potential profit for this trade is 35 cents if DIA is trading above $146 at October expiration. The maximum loss is $1.65 ($2 – $0.35) if DIA is trading below $144 at October expiration. Breakeven is $145.65 at expiration based on a credit of 35 cents.
The rationale: This trade idea on the “Diamonds” is contingent on a belief that the U.S. government will have things worked out and will avoid a default, and the market subsequently will view this as a positive sign and rally. This trade idea also takes advantage of increased implied volatility of the options.
When there is uncertainty like on a stock (or in this case, one ETF that is used to measure “the market”), options tend to increase in price because of the “fear factor” of what might happen next. When options are overpriced like they currently are on the DIA because of the uncertainty, it can be advantageous for an option trader to sell options — even as part of a spread, like in this example. If the market (Dow Jones) moves higher, those put options decrease because the right to sell the stock at a certain price (put option) loses value. In addition, options premium is composed of volatility (uncertainty), and if that volatility decreases — which might be the case if this resolution is made — the premium should decrease as well.
Click to Enlarge From a technical perspective, DIA has come down to its 200-day simple moving average. Many times the moving average will act as a support area and keep the ETF from moving lower. Plus, the DIA has not closed below $146 (sold strike) since April. We need that trend to continue.
There are two possible components that favor an options trader for this trade idea to work. If our government drags this debt ceiling crisis beyond the Oct. 17 deadline and the market reacts in bearish manner, be prepared to have an exit strategy. You might very well need one!
As of this writing, John Kmiecik did not hold a position in any of the aforementioned securities. Get a free trial of John’s live options trading room here.
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