The Market: Higher or Lower From Here?

If you are someone who has an
opinion on market direction, and is willing to take the risk of investing with
a market bias, then the current uncertain market presents possibilities.

If you prefer not to alter
your current investing program, then don’t. Stay with what works for you.

  •  If you believe we
    have seen the bottom, then adopt an option strategy with a bullish bias.


  •  If you believe we
    have witnessed a sharp bear market rally, then adopt bearish positions or make
    sure you own protection for your portfolio.


  •  If your guess is
    that the market will re-test the recent lows and then make a moderate bounce
    from those levels, you can profit by adopting market neutral strategies


  •  If you know you
    cannot predict future market direction, invest in positions that fit your
    comfort zone.


If bullish:

  •  Consider writing covered
    . If you believe the market is
    facing a large rally, write calls that are out of the money, or perhaps hold
    stock outright.


  •  Sell put
    , using out of the money index options. No need to pick specific stocks. If you are correct and the market rallies,
    you will do well. And if you are
    incorrect and the market fails to rally, you can still earn a profit, depending
    on the strike prices of the put spread.


  •  Buy call options,
    using leverage to aim for a large profit. I don’t like the idea of owning call options because it’s too difficult
    to make a profit. But, there’s always
    the (small) chance to earn many times your investment.


If bearish:

  •  Be certain you
    are not exposed to a large loss. If you
    own stocks, you have some alternatives:


o  Reduce exposure by selling some of your shares


o Write covered
calls, but remember, this provides limited protection


o Write a covered
call and buy a put. This creates a collar
and is a good choice for most investors.


o Buy puts for
protection. I don’t like this as it’s
costly to buy the puts, but it does provide good protection and allows you to
profit if the market rallies far enough.


o Sell out of the
money call spreads using index options.


If market neutral:

  •  Sell options and
    allow time to work for you

o Buy iron
(sell one call spread and sell one put spread)

o Write covered


These suggestions apply any
time you have a market bias. But, it’s
not necessary to play. The discipline of
staying with your long-term plan is always a good idea.


One Response to The Market: Higher or Lower From Here?

  1. Michael S. 07/29/2008 at 4:27 PM #

    Mark, I have a question: Let’s say I have two options that are written on the same stock; they have the same strike price, and the same expiration date. One is out-of-the-money, the other is in-the-money. Now, the premium of the in-the-money option consists of intrinsic value and time value. But why isn’t the time value of the in-the-money option identical to the time value of the out-of-the-money option? Remember, both options are written on the same stock; have the same strike price, and the same expiration date.
    What say you?
    If the options have the same strike price, then, by definition, one cannot be ITM while another is OTM.
    Assuming you meant to say that each option has the same implied volatility (IV), and not the same strike price, then the question is reasonable.
    The value of an option is dependent on several factors: stock price, volatility, time remaining, interest rates, type of option (call or put), dividends and strike price.
    For your scenario, everything is identical, except for the strike price. Because we know that each option has a unique value, we conclude that the time value of an option is dependent on the strike price.
    For example, you know that all OTM options have zero intrinsic value and that these options do not trade at the same price. Thus, they have different time values. And that remains true whether the options are ITM, ATM, or OTM.
    Time value depends on the strike price, among other factors. When all other factors are identical, then each strike price has a different time value (when expiration date is identical).