Catching Falling Knives With A Pillow

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 |  Includes: BID, POT, RIG, SIEGY, SLX
by: The Deliberate Trader

In a high volatility environment, we are interested in protecting existing long-term positions and either adding to or initiating new positions at very favorable prices. One strategy that we like to use during these times is a diagonal put ratio spread. We find that this is an effective, low/no cost way to protect existing long positions for short periods when circumstances warrant, and it is an excellent way to add to an existing core holding or even add a new one at a bargain.

We call the strategy “Catching Falling Knives With A Pillow." It involves the purchase of a near-the-money (NTM) put option, ideally to protect a security that you own, and for which you do not want to use a stop. It also involves the sale of two or more of the stock's put options at an out-of-the-money (OTM) strike price, in a more distant calendar month.

Or let's say that you don't own a particular security, but you simply think that the market will continue down from here. However, if it doesn't go down, you don't want your “bet” to cost you anything. You want to profit from the decline. And if push comes to shove, you're willing to own the stock you've targeted in your trade at a very favorable price.

To implement this strategy we employ the following criteria:

      1. The objective is to either protect existing positions or select companies whose stock you don't mind owning if the short puts are assigned;

      2. Since the emphasis is on the sale of volatility, trade only on days when the general market is selling off and is near the bottom of its recent range, with VXO or VIX preferably at 40.00 or higher (nimble traders can leg into positions, but that is beyond this article's scope);

      3. Buy NTM puts for protection or profit and sell OTM puts to cover the cost of the purchased options;

      4. Identify support areas on the charts and select strike prices that assure a very favorable entry price in the event the market sells off and the stock is eventually assigned;

      5. The entire transaction should be done at a credit so that the protection (long put option) costs nothing and the potential for assignment represents a legitimate bargain.

We find that this is an excellent way to guard against the risk of loss in troubled times, initiate new or add to core stock positions over time, and obtain the stock that we want to own at a price that we have identified as a true bargain. Here are a few potential examples.

Transocean, Ltd. (NYSE:RIG): This is the world’s largest offshore drilling contractor, providing a versatile fleet of mobile offshore drilling units to find and develop oil and natural gas reserves. The chart is 50% off its two-year high, consolidating at a triple bottom spanning almost three years. Buy November 45 puts at 3.00 or better to cover. Sell 2 May 30 puts at 2.20 for each put you purchase. If the stock price declines to 30.00 by mid-November, you make 15.00 per share on the long puts. If eventually assigned, you'll own the stock at a seven year low. If the market and RIG go up from here, you make 1.40 on the trade.

Sotheby's (NYSE:BID): From its website (click here): “Since 1744, Sotheby’s has distinguished itself as a leader in the auction world.” The chart is weak, though consolidating near support at 30.00. Buy a November 30 put for 3.00 and sell 2 January 22.50 puts for 1.50 each. If the market and BID go up from here, the trade costs you nothing. Otherwise, you make 7.50 on the long put and may own BID at 22.50.

Potash Corp. (NYSE:POT): Potash Corp. is the world’s largest fertilizer company. The world’s leading potash producer, it delivers about 20% of global capacity. Buy a Nov 40 put at 2.00. Sell 2 March 30 puts at 1.20. On the chart, 40.00 is a major Fibonacci retracement zone in the middle of a gap, which often adds support. Owning this stock at 30.00 a share would be wonderful. And if the market goes up from here, the trade costs you nothing.

Siemens Ag (SI): Siemens Ag manufactures a wide range of industrial and consumer products. The company builds locomotives, traffic control systems, automotive electronics and engineers electrical power plants. Siemens also provides public and private communications networks, computers, building control systems, medical equipment and electrical components. Buy November 90 puts for 4.50. Sell 2 January 70 puts for 2.80. Profitability on the long put is 20.00, and if we had to own Siemens at 70.00 we could easily live with that. Again, if the market rallies from here, the trade costs you nothing.

Market Vectors Steel Index Fund (NYSEARCA:SLX): The Steel ETF seeks to replicate as closely as possible the price and yield performance of the NYSE Arca Steel Index. The Index provides exposure to publicly traded companies primarily involved in or related to steel production. This ETF is off nearly 50% from its annual high. Buy a November 44 put for 3.00 and sell 2 December 36 puts for 1.50.

We didn't mention that one possibility is that the market could rally into mid-November and then plunge into the first of the year. Thus, our long put could expire worthless and we still may end up with the assigned stock. While we view that probability as low, and there is risk in every trade, we have already stated that unless you agree that it would be good to own these (or any other) stocks at the preselected prices, you should not do this type of trade. We did not choose these stocks, nor have we analyzed them for investment suitability. Rather they were chosen as examples of some popular market securities to demonstrate the practical characteristics of the diagonal put ratio spread.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.