The Dow has still been unable to regain the important resistance of 11,750 (few points here and there). It danced around that level for a while before falling like a hard rock. In this post, while I shall be sharing about Put Diagonal Bearish startegy, I shall also briefly touch upon current market state.

Dow is around 11,100-200 and the next level of key support is 11,000 followed by the July 15th low of 10, 827. As I mentioned earlier, the real important area to watch is 10,697 or so which is almost a 50% retracement of the bull market that started Oct’02 on and peaked in Oct’07.

I had earlier mention on how one can survive such a market. One of the key things I would like to highlight is that one needs to be very nimble in decision making these days. You can’t prolong the decision making. For instance- I mentioned that Gold was oversold, it bounced for a very short period but look at it now, it has turned bearish and now it is to test the level it took over 20 years to cross. I booked some gains, some losses (a lost vertical spread even for OPNewsletter) but since then I am in bearish trades for this.

How do you play bearish moves while protecting for any potential upward move?

Put Diagonal Bearish spread is one such a strategy that enjoys some excellent benefits and can be used when your analysis indicates that the price of a stock, ETF, index, or commodity futures contract has strong probability of going steadily (not abruptly) lower over the next month (s).

This Put Diagonal option strategy, can be a debit or credit spread and can be done in multiple ways depending on how aggressive you want to be. This is a good trade to do with LEAPS in combination with short-term options. In the conservative strategy, buy an OTM (Lower strike price, e.g. DIA $105) Put with 60 days or greater to expiration, and sell an OTM (higer strike price e.g. DIA $110) Put with at least 30 days until expiration and at most 30 days less until expiration than the purchased Put.

Here are some of the key features of a Put Diagonal spread-

1. Because diagonal spread is essentially a vertical spread+ calendar combo, in most cases it is a vega positive trade. I’ll keep it simple and won’t into IV smile curves etc. With the fall in underlying, the average IVs generally rises. So falling markets are Put diagonal’s friends.
2. As this is a put diagonal spread with bearish bias, it’s delta negative. Falling markets will general profits due to short delta.
3. Since you are selling short options and buying the long option, this trade is theta positive. So as the time passes by you are making receive checks from theta every day.

All key Greeks are in this trade’s favor. But one needs to be watchful. Watchful because even though it will make money when underlying is falling, it may lose money for that day. It only gains because of IV increase and with theta accumulation accompanied by partial short delta.

When to enter- You have bearish expectations for the underlying asset, but you do not expect the asset price to fall too quickly. Pay as close to $0.20-$0.50 for debit/credit (excluding margin). But do note that there should not be a big IV skew between sold Puts and purchased Put. IV skew exist for a reason and implies that a big move probably is on the way. One also need to look at the risk/reward of the trade and selecte short strike where you expect the underlying to be at expiration.

Decide when to exit- Set your exit rules in advance so you don’t have go through the emotional gyrations during panic hours. I generally prefer 15% gains for exit and 12% for loss exit but it also depends on where the underlying is in relation to expiration date. IV also plays an important role. If IV keeps falling spoiling the risk/reward, there is no point in continuing to keep the trade unless I think IV is about to rise.

Adjustments-
You may roll the short options to next month if you are using leaps/longer term options for back month. You may convert it into a calendar, vertical or double diagonal. There are various options which will be applicable depending upon the time to expiration, underlying position and IVs in addition to your outlook about the underlying move.

Key watch-out- It’s an excellent startegy and allows lot of flexibility. However, the success if this trade depends upon selection on underlying, selection of short strike, IV profile and risk management. A sound trading plan is required before executing this.

Continue to watch this space, I may share some trade ideas as we are going through this bear market. Feel free to add your comments or question to know more about the strategy.

Profitable trading, OP

According to marketwatch, LEH seems unable to raise capital and that’s what is taking it down. At OPNewsletter I was selling this rally. Here is what I wrote to OPN members yesterday-

Markets are going to the sky, moon or whichever planet you can think of. I shall share with you my version…before that…I may be completely wrong and hence take it with not just pinch of salt but loads of salt….

My version- Dow will rally it finds some resistance somewhere in between 11,560-11,600 (allow few points here and there) with a bigger resistance around 11,770….SPX will rally to 1280 area followed by resistance around 1305…I am not a buyer of this rally…till I see major buying spree coupled with a 90% up day i.e. the volume of up stocks is >90% of up+down volume..I don’t think anything significantly changed except “new hats” and workload at “printing press”…I am sensing..”It’s time to get cash, pump-up the rally, pump-up the financials and get out from here as there is no one out there who is willing to give cash”…..

but in the end, it’s just me…and I may very well be wrong…

And rest is history now. It was hardly a strong rally with less than 60% up volume (of up+down). Oh well, we still have few hours left and anything can happen. LEH’s trading volume was huge yesterday (app 2X average trading volume), so it seems it’s shares were being off-loaded amidst strong rally. My guess is that smart folks knew that the deal is probably not coming through especially after the SWFs experiences since last year.

For OPNewsletter, we reduced our Delta exposure with this rally, we closed RUT Iron condor for >+28%. In spite of all the market gyrations, as of this writing it is trading above waters.

 LEH, soon a penny stock, oh well, I may be wrong as usual,

Profitable trading, OP

The U.S. government plans to put government sponsored mortgage finance companies Fannie Mae and Freddie Mac under federal control, the New York Timesand Washington Post newspapers reported late Friday, in what could be the largest financial bailout in the nation’s history. According to the same report, Analysts at Citigroup, Merrill Lynch, and Goldman Sachs since mid-August have issued reports saying the companies had plenty of capital to operate for the near term, and both companies have successfully rolled over debt on schedule in the meantime. Also wasn’t it just a few weeks ago when both said they had plenty of capital? Welcome to Wall Street!

The two government sponsored enterprises (GSEs) own or guarantee almost half of the country’s $12 trillion in outstanding home mortgage debt. The value of the company’s common stock would be diluted but not wiped out, while the holdings of other securities, including company debt and preferred shares, would be protected by the government, the Washington Post said. Isn’t that equivalent to bankruptcy I mentioned in Dec last year, from shareholder’s perspective.

The plan, which would place the companies into a conservatorship, was outlined in separate meetings with the chief executives at the office of the companies’ new regulator. The executives were told that, under the plan, they and their boards would be replaced and shareholders would be virtually wiped out, but that the companies would be able to continue functioning with the government generally standing behind their debt, people briefed on the discussions said.

The executives were told that the government had been planning to announce the decision as early as Sunday, before the Asian markets reopen, the officials said.

Was this the reason behind a sharp u-turn, massive 200 points recovery, on Friday afternoon (something similar happened few months back when Fed had announced another massive bail-out plan)… We’re likely to see a large stock market rally on this news on Monday, But mind this, in spite of the bail-out plans if rally doesn’t happen, too bad for the markets.

After stock markets closed on Friday, the shares of Fannie (FNM) and Freddie (FRE) plummeted. Fannie was trading around $5.50, down from $70 a year ago. Freddie was trading at about $4, down from about $65 a year ago.

Read more interesting conversation and comments on this issue here.

Profitable trading, OP