A Less Risky Way To Buy The Market Dips

Now that a substantial amount of the geopolitical risk premium has been removed from the financial markets, investors are gradually starting to focus on fundamentals for their trading decisions. The majority of the data releases in the days and weeks ahead (both macro and company specific) will, however, still be tainted with residual Iraq/war worries, as these releases are calculated using March data.

Moreover, many of the positive economic developments from the past couple of weeks will not yet have made their way through the economy, just yet. As a result, the markets will still be susceptible to some pullbacks, before a gradual ascent begins, once the war is over and the economic benefits are realized. Rather than going long the markets, indices, or specific stocks on any dips, investors should consider a less risky strategy involving options...

As the market or stock pulls back, implied volatility (time value component of the option price) should simultaneously go up. Due to increased demand for downside protection, option sellers are now better compensated for the risk they are assuming. But since we believe that the market will not follow through on the downside, we can sell these puts; more specifically, we can sell a limited risk put spread.

This strategy involves selling a put with a high strike (but below where the market dips) while simultaneously buying a put with a lower strike (same expiration date). We net take in premium since the option that we are short has a greater value than the one that we are long. And, in the event that the underlying asset continues lower, the downside is limited since the long option serves as a stop loss.

So ideally, when the markets move back up after a pullback, both options lose their value, and since we sold the option with the higher strike, which is more expensive one, we end up profiting on the trade by keeping the premium earned.

Edward Allen