[Options] How to Trade a Hot Mess

Sean McLaughlin
July 21, 2021

In the recent All Star Charts monthly conference call, one of the themes that were repeated often was that stocks are in a "hot mess." In other words, many sectors are a bit stuck in the mud, offering very few signals or hints on the next direction. And when stocks aren't offering us many clues, the likely conclusion is that we'll go sideways for a while. It might be choppy, but the net result will be a whole big bowl of nothing.

With that in mind, it pays to look for opportunities to take advantage of stocks or ETFs that have somewhat elevated implied volatilities (meaning options are richly priced) and put on delta neutral credit spreads. We already did this earlier this week, and we're going to continue with another similar trade in a wildly different ETF.

Here's the chart the boys shared on the Emerging Markets ETF $EEM:

As you've probably observed, this is a very long term chart, going back nearly 20 years. So while that recent consolidation may look short, it's totally in the realm of possibility that this consolidation can continue on for at least another few more weeks.

That's the bet I'm making.

Here's the Play:

I'm selling an $EEM September 53 Straddle for approximately $3.00 credit. This means I'll be short an equal amount of 53 puts and 53 calls.

This position has theoretically unlimited risk due to the naked options, and therefore we'll trade this one small. A good rule of thumb I use to size the position is: If I were to get assigned against my short puts, the resulting long stock position should equal no more than roughly 10% of the value of my portfolio. So in this case, if I were to just short a one-lot and got assigned against my short puts, then I'd end up a long holder of 100 shares of $EEM with a purchase price of $53 per share (our strike price) which equals $5,300. I want that value to be less than 10% of my portfolio. Make sense?

Our breakevens on this trade are the strike price (53) +/- the credit we receive ($3.00). Therefore, our breakeven levels are $EEM $56 on the upside or $50 on the downside. If $EEM closes beyond either of these levels during our hold, I'll exit the trade for a manageable loss and move on. Beyond these levels and things get dicey, why risk it?

Meanwhile, I'll be working an order to close the spread for a profit when I can do so for a net debit of around $2.25. This would represent capturing 25% of the premium we originally collected at trade initiation.

This isn't a hero trade. This is a tactical hit-and-run trade for some quick and statistically likely profits. It's good to have a few trades like this working in our portfolios to balance things out.

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

~ @chicagosean

P.S. We do trades like this regularly. If you'd like to leverage Best-in-Class technical analysis into smarter directional options trades, try out All Star Options Risk Free!

 

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