Papale on Shorting the Market

By Steve Papale

Now I’m an animal lover.  We have had dogs and a few cats (those belong to my kids) and even a couple hamsters (not sure what ever happened to them).  But here’s one about a guy who really loves his…goldfish.  It seems he recently paid $500 for a vet to perform very delicate surgery on his goldfish.  Report is the goldfish was constipated and the vet successfully cleared the obstruction.  When asked what was so special about the fish the owner said “nothing”.  In fact, the fish didn’t even have a name.  Cost of not so special goldfish with no name at pet store with no constipation issues:  $2.

Traders and investors looking to take a short position in the market either as a hedge to a long portfolio or as a trade have many choices in the options markets.  First and most obvious is the simple put or put spread purchase.  The put can give the most short exposure but the put spread is probably more popular as it can be customized to take advantage of market levels the trader might be focused on.

For example, if in the SPX someone believes there is tremendous support at 2000, that might serve as a good strike to sell the put.  The put purchase side could be at any higher strike based on capital consideration or risk tolerance.  In this case, the short put simply helps offset the cost of the long put.  Of course, the cost of either the put or the put spread is based on level of the index as well as implied volatility.

As we have seen over the last couple of weeks, IV has risen, causing option prices across the board to be more expensive.  A long calendar or diagonal with the near month short option near the target level is another viable strategy.  The maximum profit of the position will occur when the underlying reaches the strike of the short option.  When the stock is higher than the target price this strategy can be put on for a relatively low cost.

A put backspread is another bearish play that under the right conditions can be put on for very low or no cost.   The trade is established by buying more far out of the money puts and selling fewer less out of the money puts.  For example we might buy 4 SPX 1850 puts and sell 2 1875 puts.  The debit depends on the relative price and distance of the strikes.  This is a long vega trade and can do well as markets sell off, especially if it is dramatic.  There is risk however.  Imbedded in the trade is a short 1850/1875 put spread.  So if the stock stops at the 1850 strike, the position is vulnerable as our short put spread loses maximum money while our extra long puts don’t make any.

 

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