Stock Option Trading Strategy – Short out of the money credit spreads on select groups.

August 15, 2007
Author: Peter Stolcers, Founder of OneOption

It looked like things might get pretty ugly this morning. Foreign markets were down big overnight in response to our market selloff yesterday. The S&P 500 futures were down as much as 10 points before the open. Prices stabilized once the CPI number came in on the light side. It will take months for the depth of the credit squeeze to be discovered. It could be a relatively contained issue, or it could be far-reaching. At this point, traders are playing it safe and they would rather error on the conservative side. That means that we are in a "shoot first and ask questions later" mode. As you can see in today's chart we made a new relative low yesterday. The market has been able to rally off of that low and rise back above support. This should not be construed as a bona fide support level until it has been tested over a longer period of time. . image . I am starting to see some opportunities on the long side. The baby has been thrown out with the bathwater. On the mortgage side, Thornburg and other premier lenders are being trashed. Cyclical stocks that are capitalizing on global expansion are also starting to take a hit. This does not mean that they won't go lower. If panic hits the market, margin calls will force traders to liquidate all holdings - good and bad. There will be some short-term short covering rallies and I believe energy, commodity stocks, heavy machinery, global infrastructure and select technology stocks are the way to play these moves. You have to be nimble and take your profits quickly. Selling out of the money puts it is the best way to play this market right now. When the market lifts off, the puts will lose some of their implied volatility and they will also lose premium because the stock has moved higher. Staying out of the money will give you room to let this wild market fluctuate. I also like selling out of the money premium on retail and consumer stocks. When it comes to consumer stocks, focus on higher ticket items like electronics. Companies tha produce non-essential goods should see continued selling pressure. The market is running scared and it has broken a number of technical support levels. Option expiration could add to the selling pressure this week. Since the market is at a new relative low, the open interest in in-the-money puts is large. That means that we could see option related sell programs this week. If the market can get through this week and stay above SPY 143, it might have weathered the storm. I would not initiate long positions until the market can produce two to three consecutive days of positive price action and close above SPY 146. The price action in the last hour of every trading day will be critical. My suspicion is that there is more hardship ahead and that we will see one more big decline before a meaningful rally materializes. There is so much negative news circulating that it seems likely that another mortgage company, FCM, or hedge fund will announce liquidity issues. Stay with the outlined strategies and you will be balanced on both sides of the market. This strategy will allow you to take advantage of the high implied volatilities and you should have time to adjust your positions since they are out of the money.

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