Stock Market – Picking the top of a rally using options

April 21, 2010

Picking the top or bottom of a long-term trending market is equally tempting as it is challenging. This post presents a trade designed to pick a short-term top in the S&P market. The most appealing aspect of this trade is that, if the position is entered and the market continues to rally, losses are minimal (per spread).

This strategy is a modification of the ratio backspread. Typically, the strike prices of long and short options are closer together; however, current conditions offer unique opportunity.

Specifically, this spread examines performance of a a bearish option spread using strike prices that are not adjacent or close together.

The margin is relatively low and more importantly, directional timing is not imperative as it would be in an outright speculative trade. It is possible to enter this position and a continuation of the current rally in stocks would present minimal losses.

The market might rally for several days and then sell off sharply. This may produce profits. The major benefit of this approach is that this strategy, made possible by current market conditions and current option pricing, allows an investor to speculate on a bearish climax in a bull market with lower risk than would otherwise be presented by an outright short position.

This trade involves buying two in or near-the-money options while simultaneously selling one in the money option.

See below image depicting this trade. The attractive risk versus reward structure of this trade is evident in the image. Clearly, a large rally may result in profit and a major sell off will result in profits. Worst-case scenario occurs if the market trades sideways over time. Note that this position is reflecting prices over a 16-day time-frame.

bearish stock market option spread

E-mini S&P Bearish Option Spread

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