Playing the Market for Less: Detailed Option Trade

With increased fears of a sell off ahead, as many have been giving high probability to a "double dip recession", I have decided the way I am going to play this market is with short term vertical call spreads on specific index ETF's, while lightening up on several of my largest holdings. I plan on using this strategy until we get a correction and I decide stocks (for the longer run) are worth purchasing again, or until I actually see the economy improving. As recently posted on my blog, I am afraid we could see a sell off after Labor Day, as more trader's realize this market is just too overbought, and decide to either (A) take profits or (B) short the market.

I have been overweight in financial stocks (mainly Goldman Sachs and Bank of America) for sometime, and on Friday I decided to take profits on the rather ugly economic data before the extended weekend. However the market has made a fool of me recently, as I have written several call options on stocks for too low of a strike price, premium, or combo of both. I decided to take profits as it never hurt anyone, but in reality this market could continue to run... I mean there is still a ton of cash sitting on the sidelines, but as we all know it only takes a few ugly statistics or stories to start another wave of selling.

I feel the best way to play this "toppy" market is to play with limited capital in the case another large sell off occurs, while capturing the majority of a continued move upward, so in this post I'll outline one option strategy which I used to trade into three major index ETF's, the Dow Diamonds (DIA), PowerShares QQQ (QQQQ), and the S&P 500 SPDR (SPY) on Friday. This post involves the use and knowledge of stock options, to learn more about this strategy, and stock options in general click here. I am still long several stocks including Goldman Sachs (GS) and Bank of America (BAC) as I have call options written on them, but the calls written on them will also help pad any losses incurred from a sell off, but I traded out of many shares of both Friday.

SPY Detailed Option Trade: Using the S&P 500 SPDR (SPY) I purchased in the money September 30, 2009 $96 strike call options (note it is the later expiration on this ETF and not the normal options expiration which is September 19). This current option is trading at delta .865 which means it will capture the majority of the move up/down (86.5%, but will change as price changes), but is trading at less then one fifteenth of the ETF share price. Each option contract was $560 at the time of purchase, but the ask as of Friday's close is $655 per option contract. Assuming a greater than 5% move up in this ETF will not occur by September 30, 2009 I decided to reduce my contract cost slightly by selling the September 30 $107 strike option against it. I was able to receive $39 per option contract which reduced my per contract cost by 7% but also limited my upside to 107 per share.

The maximum I could lose from each contract is $521, but in the event a sell off greater than 5% occurs by September 30 options expiration this would have been a wise move, as the share price would decrease by more than 5.21 points. If the S&P 500 rallies more than 5% by September 30, putting the 107 strike call option in the money, I would return more than 96% from my position in less than a month.

To better understand options in general, including this strategy, these percentage calculations, and other option strategies click here. These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

Disclosure: Long: BAC, DIA September 89 Calls, GS, QQQQ September 38 Calls, SPY September 96 Calls, Short: BAC September 18 and 19 Calls, DIA September 98 Calls, GS September 175 Calls, QQQQ September 42 Calls, SPY September 107 Calls


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