[Options] The Moment of Truth

Sean McLaughlin
May 26, 2021

JC put out a post recently discussing the weakness in small-cap stocks. He makes a pretty compelling case for why they could be leaders in a big way on the downside if the stock market rolls over here. But of course, as we've seen time and again in recent years, so many breakdowns have proven to be false and the whipsaw back to new highs has been violent.

Here's what he laid out for $IWM that has my attention:

Take a look at the Small-cap Russell2000 Index ETF $IWM. Looks like a top to me doesn’t it?

If we’re below 216, we want to short the hell out of it:

But let’s remember why 216 is such an important level. That’s the key 161.8% Extension of the entire Covid Crash, top to bottom. This is a critical price level for Small-caps.

As always, we better be sure before we “short the hell” out of anything, not just small-caps. Because we know very well that, “From Failed Moves, Come Fast Moves” in the opposite direction.

So we don’t want to get caught short in one of these either:

So 216 is the level. We can’t be short if we’re above that.

Why not retest 170? I don’t see why not.

That’s a nice risk vs reward here.

I asked JC what his time frame was for this outlook and he think it plays out sometime before the end of summer. Ok, so how do we play this with options?

I like that options volatility is pretty cheap here:

To take advantage of a big move in either direction, we're going to employ a long straddle which is long both puts and calls at the same strike.

Here's the Play:

I'm buying an $IWM September 220 Straddle for approximately $22.80. This means I'll be long an equal amount of 220 puts and 220 calls for a net debit, which represents the most I could possibly lose in the unlikely event $IWM were to close precisely at $220 on September expiration day. Of course, I have no plans to hold this position that long if it's losing.

Being long options gives us the possibility to earn theoretically unlimited gains if we get a big move in either direction.

I'm going to manage risk in this position in a bit of a unique way. If $IWM doesn't make much of a move and stays rangebound, I'll look to close this spread if I'm ever down $10.00 in it. So basically, I'll look to close it when the most I can get for it is about $13.00. At that point, theta will likely start to rapidly erode whatever premium is left in this position and I don't want to lose much more than $10.00.

Additionally, if we get a breakout of its current range, I'll look to take off the losing side. So, if $IWM trades up above 230, then I'll close the puts for whatever I can get for them. Similarly, if $IWM trades below $210, then I'll close the calls for whatever I can get. This takes risk off the table and helps improve my delta in the direction of the breakout.

If the big move we're looking for materializes, then I'll look to hold the winning options leg for as long as I can. If we're still in the position on September 1st, then I'll close it down on any retracements above/below 3-5 day support/resistance (depending on whether we're riding the calls or the puts).

If you have any questions on this trade, please send them here.

~ @chicagosean

RISK MANAGEMENT UPDATE (June 11th):

According to the plan as we laid out above, I sold the puts leg of this position as $IWM broke above $230 on June 7. This leaves us holding only the long 220 calls. I’m going to continue holding these calls as long as they stay in-the-money. If $IWM closes below our 220 strike at any time during this hold, I’ll just close the calls down and book a manageable loss. So far, the trade looks pretty good, especially if $IWM can break above $235.

 

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