This morning’s 2% down open is the latest sign that out-sized volatility is here to stay. While you can always sit on the sidelines until calmer waters return, it’s worth exploring how to use options trades for gaming the craziness.
Today’s article aims to identify three bearish leaning options trades that give the market a wide berth to zigzag without stopping you out. Given the growing number of overnight gaps, swing trading in this environment can be a nightmare. Gains today are gone tomorrow, and the market often jumps past your planned entry points.
When it comes to analyzing stock volatility, the CBOE S&P 500 Volatility Index (INDEXCBOE:VIX) is the go-to metric to watch. Super spikes like last week’s jump to 50 rarely go quietly into the night. They linger and cause the type of whippy price action seen over the past few trading sessions.
Credit spreads are one of my favorite options trades in an environment like this. Here are three bear call spreads to consider now.
Bearish Options Trades to Consider: Russell 2000 Index (RUT)
When corrections and crashes strike, the correlation between individual stocks runs to one. In other words, the stock market becomes one big blob that rises and falls together. Because it’s hard to differentiate your performance with stock picking, I usually focus on using indexes and exchange-traded funds.
The Russell 2000 Index (INDEX:RUT) hasn’t rebounded near as well as the S&P 500 or Nasdaq Composite. The relative weakness makes RUT a more attractive candidate for bear call spreads. The current recovery, while vigorous, has done nothing to change the overall trend trajectory. We still sit below all major moving averages and have resistance levels galore looming overhead.
Selling bear calls north of the 200-day near $1,570 provides plenty of room for the RUT ETF to shake-n-bake without tagging our short strikes.
The Trade: Sell the April $1,600/$1,610 bear call for around $2.50.
The reward is limited to $2.50, and the max risk is $7.50. Options are pricing in about an 82% chance of capturing the profit at expiration, so this trade comes with a very high probability of profit.
When going the stock-picking route with a bearish-leaning trade, I’m on the lookout for lagging stocks. That is, those that fell further than their peers or rebounded less. Caterpillar (NYSE:CAT) is a perfect example. It dropped some 20% from its 52-week high during the crash, sinking well below the 200-day moving average.
The snapback has all the signals of a bear retracement pattern. These counter-trend moves create lower-risk entries for bearish trades for those betting the overall downtrend continues. Rather than shorting the stock and potentially getting caught up in the chop, let’s build a bear call spread.
The Trade: Sell the April $135/$140 bear call for 90 cents.
Consider it a wager that CAT stock is unable to climb back above $135 over the next month. As long as it doesn’t, the call spread will expire worthless, netting you a 90 cent profit. Since the cost is $4.10, this options trade offers a potential return on investment of 22%.
The story on Cummins (NYSE:CMI) is similar to that of CAT. It’s in the same sector (industrial goods) and is thus driven by the same winds. Global economic slowdown fears are taking a bite out of both stocks. CMI stock’s chart exited last year on bullish footing, but has been nothing but bearish since the turn of the new year.
It now sits well below all major moving averages and has room to drop back to its 52-week low near $141. The recent three-day bounce created a lower-risk entry for short-sellers, and this morning’s down gap could be signaling the next downswing is upon us. But because of the constant gapping of the market, I want a reasonable margin of error for my bet.
The Trade: Sell the April $165/$170 bear call spread for around $1.20
The credit of $1.20 will be captured if CMI sits below $165 at expiration. The initial cost is $3.80.
As of this writing, Tyler Craig didn’t held bearish RUT positions. For a free trial to the best trading community on the planet and Tyler’s current home, click here!