Right on Direction, But Still Lose Money on Bear Put Spreads?

In 3 of the last 5 days, SPY, the ETF based on the S&P 500, gap-opened upwards but ended the day in the lower half of the day's range. The range of the day's trading has been increasing on the down-close days:

Is this a good time to play further downside in perhaps the SPY? A bet SPY will fall to at least its 50-day Moving Average? A bear put spread strategy seems ideal. It would provide a good profit if SPY made that 2-point move within the next week. But before placing that trade, let's think about this…

Checking iVolatility.com for the Implied Volatilities (IV) on SPY shows the current IV (circled in orange) is around the middle of all values in the past year:

Why is this important? A bear put spread on SPY will most likely have positive Vega, one of those ‘Greek' values characterizing an option position. A positive Vega means the option spread will increase in value from just the increase in IV, if everything else stays the same. What is the most likely way IV increases? From the underlying stock falling.

So at first this sounds like a good trade strategy. We would be betting on SPY falling, and the option trade should benefit not only from the price of SPY falling, but also the likely increase in IV as it falls. But the problem is IV is already starting rather high. As soon as buying comes in and begins to reverse the drop, the IV is likely to quickly fall (notice how fast it fell in mid-October as the SPY quickly rebounded off the October low).

While you may make a nice profit, on paper, from SPY falling over a few days, you could quickly give it back, perhaps within hours, if SPY started even a temporary rebound. That's the trouble with these trades and why many traders lose money on option trades even though they were generally right about the direction and strategy. There's more to the pricing of option positions than just the movement of the underlying security.

Even though the overall market is due for a pullback, it still is a bull market. For a few years now, pullbacks have been viewed as value propositions – buying seems to quickly come back in as investors and institutions see stocks they were considering picking up all of a sudden available at a lower price.

Environments like this make shorting stock or entering bearish option positions risky propositions. The reward-to-risk ratios aren't going to be very good. The best way to approach it is to aim for small profits and getting out quickly, to increase the chances of success. I've learned to be happy with 3-5% profits on short stock trades, and maybe 15% on bear put spreads (where I normally target quick 20% profits on bull call spreads), and try to avoid overnight, and especially over-the-weekend positions.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, type in www.markettamer.com/seasonal

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2014 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

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