The furious rally that the markets have staged over the last three months appears to be running out of steam. The consensus that we are heading for a pullback is growing every day. Many investors will try to profit from or hedge against the expected pullback by purchasing put options on the broad market proxies, such as the Spyders (the ETF which tracks the S&P 500). This type of trade makes you money when the market falls. But you are likely getting worse leverage than you could have a short while ago, making it more difficult to profit on your position.
According to a Bloomberg article, the premiums on put options have climbed recently, despite a drop in the overall options volatility (as measured by the volatility index, or VIX). This would suggest that investors are piling money into put contracts.
Add to this the increased volatility of the upcoming earnings season, and things could go south quickly. If the first week or so of earnings announcements fail to meet expectations, the slide could begin. There are just too many skittish investors waiting for a collapse to occur, and the first signs of distress could send them into a selling panic. At some point, the put options are just not going to make sense, the risk/reward ratio won’t be in your favor. This is because as investors flood into put options, they drive up the price of the options. The higher your purchase price, the lower your potential return (all other variable remaining the same).
So what can you do to make money if and/or when the market pulls back?
Buy calls.
This is a timing play, and not something to do immediately. However if the market starts a pullback, call options should get cheaper as the market falls. That is the perfect time to get into some longer term call options (LEAPs) since their premiums will be low. The reason the call premiums will be low is that as the market falls, put options go up in value and call options go down in value (think of it as a see-saw). At some point the market will turn around. It always does. And if you can buy calls when they are cheap, and give yourself a longer timeframe you can set yourself up for a nice profit when the eventual long-term turnaround begins.
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I bought USO leaps when oil was @ 35-40. They have steadily lost their value in spite of oil going to 70. What gives??
The logic is fine , but the logic does not work, however ,the risk in the long run seems to be not much, since the LEAPS w’d be very cheap, except there must be volatility & the volume,otherwise we might be see-shawed….However I w’d try…….Thx……………..