Alarming factors have resurfaced in the market recently. Some are fundamental, some technical, but all are negative!
On the fundamental side, several problems thought to be under control and improving turned out not to be. The housing market is beginning to show signs of the reality of the housing situation and not the fantasyland government skewed perception of what they want you to believe it is. Unemployment which was supposed to be getting better surprisingly dipped again.
Further, there are reports (and in my mind definite evidence) that the banks are not out of the woods and really never were according to world banking analyst Meredith Whitney who is more bearish now than ever. And let’s not forget the problems in Europe with sovereign debt and now news that the European Banks balance sheets and debts are being called into question.
On the technical side, the DOW, after making a lower low, has just put in a lower high due in part to a failure to break above the 50 day simple moving average. These factors point to the beginning of a new downtrend on the horizon. If we believe that the stated factors indicate a downside movement, our next move seems easy…..just buy some puts, right?
Well, maybe that is the right thing to do but there is a consideration. That consideration is volatility level. If we take a quick look at the VIX, we see it at 27 or so. While that is not a screamingly high volatility, it is also not low and it can create a worrisome amount of extrinsic value (value that can decay) in those puts you want to buy. In times like this where higher levels of volatility make option prices expensive, the purchase of speculative puts can become dangerously prohibitive.
In this scenario, the use of a well constructed put spread in the SPYDERS or the DIAMONDS can be a portfolio saver. Debit puts are constructed as premium collectors (i.e. selling the at-the-money put and buying the in-the-money put). If you are correct and the market gets hit, your put spread will be profitable. If the selling gets aggressive, you can always morph the spread to a straight short stock replacement put by buying back the short put. If the market stays here or drifts down a little, you have the premium collection working for you.
You have some room if the market goes up against you but ultimately have a limited loss scenario in this put spread as you can only lose what you spent purchasing it. These spreads are normally inexpensive but do provide good percentage returns in a short amount of time. So, if you are expecting downside but are worried about the cost of puts due to high volatility, look into the premium collection put spread.