While a few traders might be embracing the recent market turmoil, most are cursing the elevated volatility. The rapid-fire rips and dips cause sharp swings in portfolio values, which paves the way for a bevy of bad (read: wealth-destroying) behavior.
Fortunately, there are a few strategies that traders can employ to handle the increased market choppiness. Let’s look at just such a play on the SPDR S&P 500 ETF Trust (SPY).
One of the hardest characteristics of a market correction is the increased number of overnight gaps littering the landscape.
For the uninitiated, a gap forms when a stock’s price jumps higher or lower between one day’s close and the next day’s open. During normal, calm markets, stock prices generally don’t gap from one day to the next. If the SPY ETF closes on Monday at $206, then it typically opens on Tuesday at $206.
When the volatility beast rears its ugly head and the market becomes heavily news driven, however, prices often move substantially between trading sessions. Suppose, for example, after the SPY closes on Monday at $206, bad news hits regarding Greece or China, which sends S&P 500 index futures (which trade virtually 24 hours a day) into a tailspin. By the time the cash markets reopen on Tuesday at 9:30 a.m., the SPY might gap down to $203 at the open to compensate for all the after-hours movement.
Seven of the past eight trading sessions have seen substantial gaps in the SPY ETF. While a large up gap is a godsend for the bulls, a down gap delivers instant losses. And in a news-driven market like the one we find ourselves in the midst of, the direction of these overnight jumps is utterly random.
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With the day-to-day moves hard to divine, I like to use high-probability strategies in the options market that offer a wider profit range.
2 SPY ETF Trades
The bull put and bear call spreads allow traders to essentially bet the SPY isn’t going to rise or fall a certain amount from current levels. So, for example, with the SPY perched at $206, the bears could bet it won’t rise to $215 by August expiration. The S&P 500 ETF can gap up or down or chop around all it wants. Provided it doesn’t rally all the way to $215, the trade comes out a winner.
- Those in the bear camp interested in betting SPY prices don’t breach the $215 level could sell the Aug $215/$220 call spread for 57 cents. The max reward is limited to the initial 40 cents. The max risk is limited to the distance between strikes minus the initial credit, or $4.43.
- The bulls could obviously do something similar. If you’re willing to bet the SPY won’t fall below $194 over the next month, sell the Aug $194/$189 bull put for 57 cents. The max reward is limited to the initial 57 cents. The max risk is limited to the distance between strikes minus the initial credit, or $4.43.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
