$SPY Mixed messages. What knock-on effects to take advantage of?

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Stock market will continue its bull run...
ECB unveils €1.1tn QE plan to stimulate eurozone economy...
Larry Summers: The ECB's QE won't work...
The bubble will burst...

These are mixed sentiments that you might hear on the news and over the media. Many investors continued to buy into the all-time high in the S&P500             while other traders and investors that held a bearish view in U.S. equities last year were hurt by the continuing bullish S&P             growth and threw in the towel trying to short the market. What probably hurt even more was that this growth was "stable" in the midst of escalating geopolitical tensions, poor economic news releases, outright war in certain countries, and questionably experimental central banking policies.

Where will the market go this year? What is the next price level on the S&P500             for it to hit on the upside? If there is a crash, how hard would it crash? What level should I get out at? Should I buy gold? Will Oil             go back up?

The way I approach these questions to plan a trade or investment is less direct. Calling a market top or a market bottom or a specific price level is tough. I can watch the price level and the market's reaction to it, but am unable to predict with certainty whether a bounce would happen or whether prices would just fall through. What I can try to do however, is assess my options and ask myself, IF a scenario happens, what would it lead to? What knock-on effects can I take advantage of? What would be a low-risk, high-probability and high-reward trade that I can take on?

This is the S&P500             crash or downtrend scenario and here are some of my thoughts.

*** If the S&P500             does crash this year or falls into a downtrend ***
I see a huge opportunity to make use of the artificially suppressed volatility in the SPY             (the ETF that tracks the S&P500             ) to buy long-term out-of-the-money (OTM) put options, like the SPY             Jan 15 '2016 170 Strike put option. This is a long-term bet and more of an "investment" rather than a trade. More on why OTM long-term put options below.

Some of us have read about the volatility index ( VIX             ) being artificially suppressed. Meaning that someone is pumping in a lot of money to short the VIX             , leading to artificially "low" volatility . From my POV, suppressed volatility means that it is cheaper to buy long-term options. In the event of a crash, the volatility will spike to an even greater extent, and again, increasing the value of your options in the event you wish to sell them or exercise them. Think of a spring-coil - the more you press it down, the harder it will spring back up. This knock-on effect is something to take advantage of.

From the chart posted above, you can see that I bought some cheap SPY             Jan 2016 Put Options, and will continue to do so if and when the market rallies again. I have also sold a portion of them already. One part of my strategy is to sell off a portion of my options for relatively decent profits that should cover my option premium and continue to finance more put options at key levels, whether higher or lower. The key here is not to take profit too early when the market does move downward but always leaving a portion of the position open. The market tends to fall much harder than when it rises. Expect to see bigger downside moves in shorter periods of time.

Take note of the two price channels drawn above (drawn with blue lines, and with red lines). If and when the price of SPY             falls below and breaks below the channel floor/support line and trades there for a sustained period of time, i.e., 3 to 4 days, we can expect to see an accelerated downside move that follows.

Continued in comments section...
*** But what if it doesn't and the S&P500 keeps going higher? ***
Your losses are limited by the option premium and you don't have to worry about losing more than you expected. There are no "stops" to be triggered and you don't have to worry about your stop orders not being executed well. Come January 2016, the maximum amount you can lose is limited to how much you paid at the start when you bought those options. Again, more on this below.

*** What if I still want to keep going? Maybe 2016 will be the year the market crashes ***
These OTM put options are cheap. You can roll them over to later expiry dates for an additional cost. The cost of holding these options is known as time decay. You can read up on time decay if you wish to - Google "theta" .
*** Why OTM Long-Term Put Options? ***
Firstly, these are more like investments. The intent is to buy them and "forget" about them - not having to continually check back on a daily prices on their price levels. If you want to, that's absolutely fine, but the risk is that you might exercise them too early. These OTM long-term put options are such that the premium you pay for the put options - the cost - is essentially your "stop loss" or capital at risk. This pre-determined amount can be easily calculated and managed given your own risk appetite. You will not lose more than this amount - unless you purchase more put options of course.

Secondly, the payoff from these out of the money options are asymmetric. That means that when you are losing, like when the market continues to climb higher, you lose the value of the option at a decreasing rate, but when you are winning, the market starts to decline, your option value suddenly starts growing at an increasing rate. In options greek, this would be your gamma and delta, which works in your favour in this scenario. So where you really start to make money is when your OTM options become in the money and you have a high delta. Compare this with shorting the SPY or ES (S&P500 Futures), when the market moves against you and climbs higher, you lose capital at the same ratio as you would gain capital if the market moves in your favour.

Thirdly, you don't have to be afraid of getting "stopped out" as you would when shorting the SPY or ES. For example, let's use the maximum potential loss you could make on your put options, the cost or premium you paid for the option. If you translate that amount to the amount you would risk when shorting SPY or ES, you would have a price level above equivalent to the maximum amount you would risk. The price level could be hit before the market turns lower and that is one of the biggest frustrations that a trader could face. With options, there is no price level that will "stop" you out of the option. With options, its the time expiry of the option that will "stop" you out.
*** Volume and Open Interest ***
When buying options, it is always important to look for high volume and open interest. This provides the liquidity to get better fills in terms of probability on your entry price, a narrower spread in general, and the likelihood of you being able to close out your option at a better price when you choose to take profit. The SPY Jan 15'16 170 put options have relatively high volume and open interest and would allow for good fills.

*** Key Price Levels to Take Profit ***
Looking at the S&P500, here are some key price levels to take profit and close a portion of your put options.

1703.5, which is the 38% Retracement Oct 11 to Dec 14. You might consider closing 30% to 50% of your put options here for a decent profit. Wait for a bounce to buy more put options or keep the profits.

1550, which is the 38% Retracement Feb 09 to Dec 14. Consider closing another portion of your put options here for a huge profit.

My target to close all put options would be the 1047 price level on the S&P500 if the market does crash, which is around 48.5% from the all-time high so far and a key support level in the years 2001, 2002, 2004, then again in 2010, 2011.

*** Risk vs. Reward ***
With the price level targets set above, these put options are looking conservatively for around a 5:1 profit to loss ratio or alternatively reward to risk ratio, for example, when closing all remaining positions at the 1550 level. This means that for every $100 you put in options, we are looking for a $500 profit target.
*** George Soros has bet more than $2.0 billion USD on OTM put options according to some news releases ***
The legendary investor/trader has been building up his put option on the SPY for awhile now. The first big position was $536 million in SPY Put Options in mid-2012, then $1.3 billion in 2013/2014 and raising it to $2.0 in Q4 2014. Some pundits say it could be hedge, some say its just a notional value that could decrease and increase dramatically and the true value of the options could be a lot less. But the fact is, he's buying put options on the SPY.

Watch out for my next piece on call options on USO, an ETF that tracks crude oil prices. Different scenario, different strategy.

Fixed the labels
Hope some of you bought put options in the area flagged in the chart!

Time to take some profit!

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