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Use a Ladder to Navigate a Big Drop

|Includes: SPDR S&P 500 Trust ETF (SPY)

Now that the S&P 500 Index has materially cracked the 1040 level traders are beginning to eye just how far the next step down can take us.  Even though the first sign of support comes at the 980 level numbers such as 930 and even 875 seem to be growing in popularity as possible downside targets. But given the steep slide and spike in implied volatility that has already occurred buying puts right here can be a risky prospect. If the market stabilizes or bounces even moderately the loss of premium could be quick and substantial.  One strategy that could be employed to gain downside exposure but at minimum cost and risk is called a ladder.  

A ladder involves selling a closer to the money option, then buying two options that are both at further out-of-the-money strikes.   Think of as selling a credit spread to help finance the outright purchase of an out-of-the money option. 

Step on Down 

Let’s look at the Spyder Trust (NYSEARCA:SPY) as an example.  Tomorrow’s jobs data could certainly provide a catalyst for an acceleration of the decline the impetus for a snapback rally. With the SPY trading at $102.25 one can: 

-sell 1 July $104 put at $3.80 a contract

-buy 1 July $100 put at $2.10 a contract

-buy 1 July $98 put at $1.50 a contract 

This three legged position is down for a 20c net credit (The amount received from the sale of the $104/100 spread –minus the cost of the $98 put.)  This is a low cost way to establish a long gamma bearish position. It is similar to a ratio spread.    

If stocks rally back above $104 you collect and keep that 20c, no damage done. If you stocks plummet down through the $98 level you are net outright long the $98 put and profits will accrue as prices decline. The risk or maximum loss is limited to $3.80 and would be incurred if the SPY is above $98 and below $100 on the expiration day.  Essentially the area between $98 and $104 is the dead zone in which a loss, the amount depending on the price of the underlying would be incurred. 

But for those anticipating a large downside move, or wanting to gain low cost protection, without losing anything should stocks stage a rebound, using a ladder is a safe way to navigate a decline

 

Disclosure: Short SPY