This is an excerpt from Cabot Options Trader, your guide to quick profits using puts, calls, spreads, straddles, iron condors and other options trades. Analyst Jacob Mintz explains and recommends diverse investing strategies for big gains with controlled risk.
Extreme volatility came back into the market last week as the Dow had its biggest weekly drop in three years amid concerns over the ramifications of oil’s rapid decline. For the week, the S&P 500 lost 3.52%, the Dow fell by 3.78% and the Nasdaq dropped 2.66%.
For the bulls, the price action of the past week would at the very least raise some concerns. However, the average gasoline price fell to $2.60, the lowest level since 2009, and likely in direct correlation to the falling price of oil, U.S. retail sales and Consumer Confidence beat expectations.
For the bears, one week’s losses wiped out five weeks of gains for the S&P 500. Also, the Athens stock market fell by 20%, Europe continues to worry about deflation and Chinese factory production growth slowed more than expected.
The Chicago Board of Options Exchange Volatility Index (VIX) closed the week at 21.08, a gain of 78% for the past five days, and the biggest weekly rally for the “fear index” in more than four years.
In this volatility section last week I wrote, “At this point, traders are talking about a VIX in the single digits as there seems to be nothing that can stop this market's advance, and conversely, the VIX's drop. However, every time the VIX broke below 12 this year, it was followed shortly by at least a small market correction and a pop in the volatility index.”
And right on cue, the market dropped 3% and the VIX spiked 78%. By no means was I predicting such a move. However, over time I’ve learned that when market protection gets as cheap as it was last week, buying puts on the market for insurance is a good risk/reward proposition.
Events for the Week to Come
Traders will likely be very focused on Wednesday’s Federal Reserve announcement on interest rates and the Chairwoman’s press conference to follow, to get a hint at their views on the economy and potential rate hikes in 2015.
That said, the falling price of oil continues to be what traders have been watching most carefully over the past several weeks, and that’s likely to continue.
What Traders are Saying
For the past several weeks, I’ve raised concerns about the ramifications of a rapid decline in the price of oil. Yet the market continued to make new highs for weeks, and as recently as six trading days ago the bulls were celebrating the potential of Dow reaching 18,000.
As I wrote two weeks ago, “One other concern that I highlighted is the effect that this dramatic fall in the price of oil may have on the bond market, as the energy sector makes up a large segment of the high yield bond market. While it's too early to tell if there will be significant damage to the high yield market, we need to keep an eye on this as there could be a chain reaction of de-risking, default and outflows.” This concern is now clearly becoming an issue as it’s widely assumed that if oil remains at these levels, many of the highly leveraged oil companies could be at risk for bankruptcy.
As concerning for many traders as oil companies not being able to pay their bills, is the growing worry that countries such as Russia and Venezuela could default on their debt, or begin to “act out.” (The Russian government gets half of its revenue from oil and gas exports and it’s widely assumed that Venezuela needs oil to be significantly higher than $100 a barrel next year to balance its budget.)
While these are potentially significant issues, I should point out that when the market dropped 1.6% on Friday afternoon, the VIX only gained another 5%. I would have expected a much more significant run for puts and protection into the weekend as the market was making new lows. This lack of a panic could be a “tell” that we are nearing a short-term bottom. In times of great uncertainty such as this, the VIX is a great read on fear in the marketplace and something to watch now that it is once again above 20.
Jacob Mintz is Chief Analyst of Cabot Options Trader, and a professional options trader. He has developed a proprietary risk management system for options trades.
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