The last couple weeks witnessed a short covering rally in equities, which ignited during a US holiday on Monday February 15th, 2016. This price appreciation started to look suspect on Wednesday as prices climbed but volume weakened and stayed at low levels.
The message being sent? The buying took place on traders closing their short positions, instead of big money stepping in to buy with expectation of higher prices. We then saw a pause in the upward move over the next two days (Feb. 18 and 19).
The price can continue to rise even when conditions don’t favor it…so this S&P 500 short trade only occurs if the price actually starts to drop again.
Looking at this 15 minute chart of the S&P500, a few things are taking place:
- Price failed near the 1940 resistance level (and price is testing that area again on Feb 22 morning).
- The price failure occurred at another key resistance, the 50 day moving average on the 15 minute chart (which is also approximately the 20 day moving average on the daily chart).
- This peak was lower than the previous on February 1st–a lower high occurring after a lower low.
- This suggests a downtrend.
- Momentum and Stochastic are both rolling over to the downside.
- RSI is flat, showing lack of upside momentum.
There is bullish divergence on the MACD, both on the 15 minute and daily charts. This warrants some caution on the short side. So instead of getting into a short trade on the open on Monday (February 22), I will wait for a bit more confirmation.
Examining the 4-hour chart gives us some short-side confirmation:
- Price top seems evident on this time frame, but the 1900 level was defended on some decent volume
- Momentum, RSI and Stochastic are all signaling overbought conditions and a potential short-term selloff.
- The MACD on this time frame is bearish, indicating the price may be ready to drop to support at 1872 (the 50% Fibonacci retracement).
Because volatility is relatively low, and I expect the S&P 500 to drop, I am also expecting volatility to increase. This leads us to the debit spread option strategy. Being a little concerned with the bullish divergence on the MACD means I want some coverage in the event volatility drops and the price continues upward. These conditions call for my favorite strategy – the debit vertical spread using put options.
Here is the trade plan:
1) Enter when S&P 500 breaks below 1895.
2) Buy the 1900 March 11th put option (establishes the bearish trade).
3) Sell the 1820 March 11th put option (reduces cost of the trade but also caps profit to this level). Think of this as your profit target.
4) There is no stop loss, but the entire cost of this trade should be less than 2% of your account equity.
Tip: If the cost of the trade is more than 2% of your account equity, you can short a strike price above 1820 to reduce your cost (but this will also reduce your profits). Experiment with 1850, 1860, etc, until you get the cost down to an acceptable risk level.
Currently the price is not near 1895 (it’s near 1936 in the pre-market on Feb. 22), so we can only approximate how much this trade will cost using the current SPX option chain.
The long 1900 put will cost approximately $3,380.
The short 1820 put will generate approximately $1,110 in income.
Total cost of trade = $3,380 – $1,110 = $2,270
Profit potential = ((1900 – 1820) * 100 ) – $2,270 = $5,730.
Based on the $2,270 initial investment we stand to make 252%.
If approximately $2000 is more than you want spend on a trade, for a lower priced alternative use SPDR S&P 500 ETF (SPY) options (instead of SPX options). Trading one SPY contract will cost a couple hundred dollars instead of a couple thousand. The math still works…you spend about $200 to make a little more than $500. Trade multiple contracts to increase your potential gain (remember the 2% rule though).
That is the nice thing about this strategy: there are ways you can trade it whether your account is small or large.
Could the price go up? Sure, but then the price likely doesn’t trigger this trade at all. And if the price drops and then rallies, our downside risk is limited to the cost of the options.
This is a great trading strategy to reduce your cost base but still make big returns.
I know the strategy can be a little tricky to grasp at first, but this strategy is favored by a lot of professional options traders…who are obsessed with controlling risk and utilizing capital efficiently (look at that potential return!).
Join me for a free debit spread options trading webinar, and learn more about this powerful options strategy.
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