Wow, what a week I missed in the markets! A wild week full of opportunity seems to happen every time I go on vacation. Maybe it’s a good thing I’m chained to my desk until next summer….
Do keep in mind Barron’s and Options Action content both have comments that were made before the S&P downgrade of US debt that occurred late Friday.
Steven Sears discusses my favorite topic, the VIX, and the hedging possibilities of using VIX options. In last week’s column Michael Schwartz of Oppenheimer had recommended hedging against a drop in the stock market using a bullish spread with September options. That spread has returned 100% in just a week’s time. The recommendation last week was to Buy a VIX Sep 24 Call and Sell a VIX Sep 30 Call. It is recommended that if you believe the market turmoil is not over you may want to take a look at Buying a VIX Sep 32.50 Call and Selling a VIX Sep 37.50 Call. Pricing is based on Friday’s close, but the cost of this spread would be around $1.00 with a potential profit of $4.00 based on a continued run in the VIX.
Options Action –
The guys started out reviewing the very volatile day that occurred in the markets Friday. The belief was some of the rallying was short covering that was prompted by news coming out of Europe. The feeling is that the markets were still a bit nervous toward the end of the day on Friday, but traders were not necessarily putting on new positions.
The first stock discussed was Bank of America (BAC) which closed on Friday at 8.16 which is the lowest shares has traded in several years. It was also noted the January 7.50 Puts were very active on Friday which indicates a bearish outlook over the next few months.
Even though the stock is already down 20% in just a few weeks, the trading recommendation was for a ratio put spread with expectations of the stock trading down to 5.00 a share into January 2012 expiration. To create the spread, two BAC Jan 2.50 Puts are sold at a total of 0.25 and 1 BAC Jan 5.00 Put is purchased for 0.35. The net result is a cost of 0.10 for this spread. The payoff is pretty interesting.
At January expiration if the stock is between 4.90 and 0.10 the trade makes money with the maximum potential gain of 2.40 if the stock settles right at 2.50 at expiration. The maximum potential loss for this trade is 0.10 with the stock anywhere above 5.00 or if the stock has no value at January expiration. This may be a trade worth taking a look at again later this week after the markets settle down a bit.
The second stock discussed is 3M (MMM) with a bullish outlook with the stock under more pressure than the overall market and trading right on a long term uptrend line. The idea is this is a pretty solid fundamental stock that is a bit oversold. If the market recovers this stock should outperform the overall market.
The MMM trade is a risk reversal when a put is sold and two calls are purchased. The recommendation is to sell 1 MMM Oct 82.50 Put for 4.70 and buy 2 MMM Oct 87.50 Calls for 2.10 each or a total of 4.20. The net result is a credit of 0.50 to initiate the trade. As long as the stock is over 82.00 on October expiration the trade will make a profit. Again, this may be something to revisit after the market has settled down a bit after reacting to the S&P downgrade.
What a great week to return to the markets if you like volatility. Volatility is always an indication of fear in the markets and fear often results in opportunity. Be nimble this week and see if some opportunities pop up for you.