The October Massacre of 2008 ended with a sharp rally – the major indexes gained 10.5 (SPX) to 14% (RUT; Russell 2000 Index) during the final week of the month. But it was still a down month.
If you are going to play the market now, the big decision must be based on the belief that the market has found a bottom and is now rallying, or we are seeing a strong rally in an ongoing bear market. I must admit that I have no basis for choosing either.
Traders don't have to make long-lasting decisions as they have the ability to move in and out of positions quickly. But it's a different story for investors.
For bullish investors:
- If very bullish, your major decision must be whether to hold unhedged positions, allowing for the possibility of significant gains – but being exposed to large losses if you are wrong. You can buy stock or calls. If the market rallies, the implied volatility of those calls is going to decrease, so it's best NOT to buy out of the money options.
- If bullish, but you want minimum downside exposure, you can write covered calls or naked puts – but those choices are too risky for my comfort zone. How about yours?
- If bullish, but want to minimize losses, a reasonable strategy is to buy call spreads or sell put spreads
- If you are like me and have no idea what's going to happen next, you can adopt a market neutral strategy and buy iron condors. With current volatility, I suggest being a bit cautious and don't take on more risk than feels comfortable. This market has the potential to explode 1,000 DJIA points in a day or two – in either direction. And then it could easily do it again.
- If you believe this is a bear-market rally, you can sell calls spreads or buy put spreads. These strategies limit losses if you are wrong in your prediction.
- If bearish and you want to gamble, you can buy puts to go for a big win. But those puts are expensive and if the market continues higher, you will lose twice: Once because the market is rising and again because the IV of those options is going to tank. I don't like gambling with options and hope you avoid this choice.