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IMPLIED VOLATILITY


For TNA, A Short Put Play

11/05/09 11:45:29 AM
by Donald W. Pendergast, Jr.

When fear gets factored into market prices, option premiums become expensive. Learn to use this dynamic to your advantage.

Security:   TNA
Position:   Sell

Say the markets may be attempting to make a meaningful swing low, one that may hold for at least a week or so, but you're unsure how to gain a trading edge in a market that, well, just looks so iffy. Why not consider putting the power of extreme implied volatility to work for you in a trade that has two mathematical edges going for you, right from the start? Here's a simple put sale idea in a triple-leveraged small-cap index exchange traded fund (ETF), one that promises no shortage of powerful moves both up and down, the ETF for the Russell 2000 index (TNA). See Figure 1.

FIGURE 1: TNA, DAILY. With TNA showing such formidable support near $34, selling a highly inflated $32 put option with only 11 days of time value remaining looks like a solid, low-risk play.
Graphic provided by: MetaStock.
Graphic provided by: WB Detrend EOD from ProfitTrader for MetaStock.
 
The basic premise of this short put trade is this: The Russell 2000 has very likely made a swing low over the last few sessions and should begin to retrace at least a portion of its sizable drop since mid-October 2009. Now, if you don't agree with this market timing premise, and your own technical work is suggesting otherwise, just ignore the rest of this article. But if you also believe that the Russell 2000 and the TNA have made a solid daily low, read on.

During the recent plunge, option premiums rose dramatically, with implied volatility readings moving well above historical norms, and they're still generously valued due to the belief that the downdraft may only be in its infancy. That's our first edge -- fat option premiums to sell back into the market. The second edge is this: We'll sell substantially out of the money, near-term expiration put options on TNA, options that will lose significant amounts of time value every day between now and November 20, 2009, which is option expiration Friday. See Figure 2.

FIGURE 2: TIME AND VOLATILITY. Even with an average implied volatility of more than 100%, there's still only a 31% chance that a short $32 TNA put will expire in-the-money come November option expiration.
Graphic provided by: Option Wizard Online.
 
Since TNA appears to have major support near its 200-day exponential moving average (EMA) (near $36) and then just below at both the August swing low of $33.83 and the recently completed low of $34.22 (made on November 2, 2009), we're going to sell a November 2009 TNA $32 put option (TIJVW) for $1.40 or better. That's $140 cash right up front, paid into your margin account; if TNA expires at $32 or higher in two weeks, you keep all that cash (less sales commissions) and count your blessings. You can also close the trade out early if you like, buying the option back at a profit or loss, depending on TNA's price action over the next 11 sessions. See Figure 3.

Right out the gate you receive the edge of generous premiums, ever-accelerating time decay (which is a wonder to behold) due to the short lifespan of the option and significant chart support levels separating the current price of TNA from that $32 option strike price. All in all, this trade appears to have a lot going for it. Even better, TNA has only a 31% probability of expiring in the money on November 20,2009, and that's calculated using the stock's current, highly inflated implied volatility reading of 100%.

FIGURE 3: TRADES. Imagine getting paid $140 up front waiting for a relatively overvalued put option to expire out-of-the-money. However, if the trade doesn't pan out, wise traders will buy the put back before it doubles in price and/or it goes in-the-money.
Graphic provided by: ThinkorSwim.
 
If TNA begins to falter soon after trade inception, there is no need to panic. Just monitor the aforementioned support/resistance levels and close the trade out if you see the stock fall strongly through the lower support level of $33.83. Alternatively, if the option premium should happen to double (most likely on a sudden spike lower), just buy it back, no questions asked. In every other scenario, however, just plan on holding the short put until expiration, unless you simply must cash the trade in early and grab the profits because of the fear of another round of heavy selling in the market.

Selling puts in volatile markets isn't every trader's cup of tea, but if you have a solid grasp of implied volatility, time decay, support/resistance levels, and cycle/swing trade dynamics, you may find that this is a great way to boost the value of your trading account's equity. Just make sure you employ strict risk control to bail out of the occasional trade that goes haywire.



Donald W. Pendergast, Jr.

Donald W. Pendergast is a financial markets consultant who offers specialized services to stock brokers and high net worth individuals who seek a better bottom line for their portfolios.

Title: Writer, market consultant
Company: Linear Trading Systems LLC
Jacksonville, FL 32217
Phone # for sales: 904-239-9564
E-mail address: lineartradingsys@gmail.com

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Date: 11/05/09Rank: 3Comment: Thinly traded options. It seems safer to establish a similar trade on IWM.
Date: 11/05/09Rank: 3Comment: 
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