The “smart” way to play a FTSE retracement….

With the FTSE still refusing to make any material move to the downside and so confounding the bears (we also put on a short at the 6270 level), even in the face of the most overbought (on a daily RSI basis – see below) measure since May 1997 and now putting 10 up weeks out of 11, we think it’s time to look at an interesting option strategy to play this instead of facing the risk of a blow off top.

We think we are within days of a sharp snapback to around 6100 however with evidence of capitulation by the bulls. CNBC ran a story last week “Bears on the Brink: I Can’t Fight It Anymore.” Even the normally staid Alan Abelson of Barron’s finally threw in the towel last week, abandoning his own caution that stocks have run too fast, too far, and suggesting that investors let their profits run “until they start to go the other way. After all, markets rarely fall out of a bed in one fell swoop as they did in 1987 and, more recently, the turn of the century, so there’s usually plenty of time to cut and run …” Of course, there usually isn’t plenty of time to cut & run…

The beauty of options is that, certainly for ‘paid for’ premium, you know exactly what your downside is – the premium paid. The additional benefit of an option strategy at this point in time is that a key component of an option price – volatility – is trading near historic lows. This makes options cheap to buy – precisely what we want in order to make the trade cost effective. Should the market retrace then volatility is likely to rise too and so we get a double whammy.

Here’s a strategy we’re going to put on – Purchase the March 6150 Puts @ 56 and sell the same amount of the Feb 6150 Puts @ 13. The reason we sell the Feb 6150 Put is because the time decay will begin to set in in around a weeks time should the market not reverse. If the market does indeed reverse then we will make more on the 6150 MArch Put option due to the enhanced embedded time value here.

Now, if the market does fall sharply to say 6150 and volatility rises, we will then sell the March 5850 Put and potentially cover the Feb 6150 Put to capture the premium differential between the two (probably around another 40 pts depending on the timescale of a reversal) depending on the timescale when the fall occures. In such a scenario, we mat get the cost of our March 6150 Put down to almost nothing in which case we would simply sit on the option to see if/how profits accrue before adjusting the position. The max profit we could make would be the difference between the 2 strikes – 300 points but at say £50 per point – it would certainly pay for the flights to South Africa this year!

If the market continues to rise however, then we have mitigated the cost of the March Put by selling the 6150 Feb one and we still have the flexibility to sell say a Feb 6450 Call should the market blow off.

In a nutshell, we have time on our hands, are positioned for a fall without losing sleep or being stopped out, are paying low premium for the downside punt given the low volatility measure at this time and have flexibility to sell a Call should the market rally further.

We are, in such a strategy, addressing an issue that has befallen many a great trader before – “the market can stay illogical longer than the investor can remain solvent”.

If you want to learn more about how options can help you in your trading and add another dimension then be sure to download the Guide below that we wrote.