Trading Volatile Markets Using Options: S&P and Crude Oil

By Tom Mikulski

We have seen quite a sell-off in the stock market in the past few weeks, and I’m sure if you’ve been watching the news, you know exactly what’s caused that and don’t need me to describe that for you. At the same time, we’ve seen a big correction in crude oil. I will offer some strategies on how you might approach trading in markets that are extremely volatile, as the S&P 500 and crude oil both have been.

On the daily chart of the December E-mini S&P 500 futures, the moving averages that you see are as follows: the blue is an eight-day moving average, the red is a 21-day moving average, the green is a 50-day moving average, and the black is a 100-day moving average. On a technical basis, the market is getting near major support near 840-850, and seems to have hit bottom for now. There was a nice little bounce off the bottom near that range, where the market spiked back to the eight-day moving average before turning down once again. It didn’t fall quite as far in the past week as it did on the first big sell-off, when the government approved the bailout package and was greeted with trepidation. December S&P futures have not come close to the 21-day moving average yet at 1052.00, which will be very significant on a daily closing basis to suggest that the market could at least be at a short-term low, trying to consolidate at higher prices.

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Using option strategies in a market like this a can be very, very difficult. I tend to pursue safety over greed. I would rather be as far away from the market as possible when choosing to sell options. Getting too close to the underlying futures’ price opens yourself to an unnecessary amount of risk. During this current uncertain market environment, I am really adverse to selling options. Buying options could be a very good alternative, however, if you’re hoping or speculating that the market will turn around and move higher. Buying calls could be a very good alternative to buying futures because your risk is defined as the amount you pay for them. So if you have $500 you are willing to risk in the S&P futures, for example, you could buy the 1100 November call for that amount, which expires on November 21. That gives you over a month of time to get close to that level, and hopefully turn a profit. You know your potential profit is limitless, and your risk remains defined as the $500 you paid for the option.

If you think the S&P is going to turn lower, buying a put would be a good alternative, because unlike a futures short position, with options, you don’t have to worry about this daily chop we’ve been seeing. These huge daily and weekly ranges tend to stop out smaller investors, even if you are right about the direction of the market over the longer-term. For example, you could buy an 850 or 900 S&P 500 put, which would probably run you about $1,000, depending how close to the underlying futures you get, and your commission costs. Once again, your risk would be the amount of money you pay for the option and your potential profit is unlimited, as long as the market continues to trend in your direction.

Now also keep in mind, with options you still have to deal with volatility. When the market is trading large ranges like we’ve seen, it does add premium to options prices. So if you are buying an option, high volatility could make the option a little bit more expensive. If volatility were to drop, you might see a drop in the value of that option. That means you really need to be on the right side of the trend to be successful buying options. But at the same time, buying options tends to have a better risk profile than trading in the futures.

If you do choose to short options in a market environment like this, I recommend selling options that are counter-trend. For example, the market has been in a very steep downtrend over the past month, and while it seems to be trying to form a base, it still has not gone above major technical levels that show that the market is truly turning around. If you are looking to sell options and you could get decent premium, I wouldn’t recommend trying to sell anything below the 1150 or 1100 strikes if you can help it. If there isn’t enough premium there, then it probably isn’t worth the effort because you are taking a lot of risk for almost no reward. You would not want to sell puts when the trend is down, you want to sell calls because the trend is not bullish. I would recommend selling calls below 1100, because the market could bounce and subject you to a lot of risk (i.e. premiums increasing, thus hurting your position).

If investors don’t have a lot of faith in the current economic stimulus package, and if a lot of these different companies have really bad earnings, the market could head back to lows again. Be careful about opening yourself to a lot of potential risk if you choose to sell puts.

Crude Oil

Crude oil has been falling along with the stock market on ideas the global economy’s weak state will reduce the demand for energy. However, crude oil futures have seen a slight rebound over the last couple days on news that OPEC is considering a cut in production. This has given some legs to the market, and futures have bounced off support near $68 a barrel.

The market is still in the bottom of its recent range, and before it broke below $90, I had been a big advocate of short options strategies, particularly strangles where you would be short calls and puts. That was successful when the market was above $100, but once it started to trend strongly I recommended getting rid of the short puts as I believed crude oil was going even lower.

At this time, I’m not sure how long rallies will last. I do believe that if OPEC cuts some production, there is a chance the market could climb back above $80. If you share that belief, buying calls might be a good alternative at this time to buying futures. This market has been very choppy, and the swings can be a big headache for smaller investors. There’s nothing more frustrating than getting stopped out on your trade when the overall market goes in the direction you thought it would, but bounces around during the day and hits your stop. If you want to participate in the market, you can consider buying an option to help at least control your risk amid all the volatility.

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Once again, if you want to sell options in this type of environment and think the market is headed lower, try to sell calls as far up as you can, away from the underlying market price. Inflated premiums on the call side should give you a little more value if you are selling. If you can sell 95 to 96 calls or higher, that’s what I recommend to give yourself a little bit of wiggle room in case the market does start to move against you.

Overall, if you are trading in either of these markets, be very mindful of your risk. I can’t stress that enough. Not everybody has deep enough pockets to survive the extreme market moves we’ve been seeing. If you are easily frustrated, then I suggest perhaps staying on the sidelines, and waiting for another opportunity. That’s the great thing about the markets—there will always be another chance to trade.

Please feel free to call me at 800-643-4455 or contact me via email at tmikulski@lind-waldock.com if you have questions on this topic or to discuss specific trading strategies for your unique situation in this or other markets.

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