I have been getting many questions asking, "What do I do now that the market is falling"? That is a great question – one that deserves an answer.

The good news is the market is a little weak. However, people have been so lulled into a slow and advancing market that a small correction has them on pins and needles. It is almost as if they forgot the years 2000-2002, when 500-point moves were common and the NASDAQ lost 80% of its value in 2 years. But that is what makes trading so much fun, so challenging, and sometimes easy (but most of the time hard). People have a short attention span. I have already gotten up to change the channel 3 times in 2 paragraphs.

We need to keep a couple things in mind when looking at the big picture:

• The market is up about 18% since the lows of July 2006. In 8 months we have had a tremendous run up. To have one day where the Dow falls about 500 points (around 4%) is not only nothing, it is expected and healthy.
• Despite what the talking heads on television say, this economy is very strong and resilient. We have spent over $1 trillion on George Bush's "$80 Billion War." A lot of that money is filtering around this country too.  
• People were complaining for so long that the VIX was broken and could not give any real information again, that it was bound to surprise everyone.
• The markets are going to do whatever they can to surprise the largest amount of people. If you think about that deeply, it begins to make sense. There is a fine line between being a successful trend follower and a successful contrarian.

So what is the market going to do now? I personally didn't see enough capitulation and fear to determine and feel comfortable with the fact that all the weak bullish traders got frightened out of the market, which is one of the biggest requirements for making a bottom. In addition, many people view yesterday's (April 6^th) 150+ run up in the Dow as a "key reversal day." Finally, anyone who sold volatility on a 20% did not sweat for one second and is probably making a lot of money. So what does that tell me?

The sell-off is likely not done. I would like to see one more deep scare with the VIX >20% before I say the bull trend is going to continue. Don't worry about Shanghai. Their market doubled in a year and at one point was up over 170%. That had to slow down and reverse at some point. The one-day sell-off did adjust some attitudes with the overall public's bullish sentiment of 54% bullish going to 36.5% bullish in one day, but a little more of the whiner-ectomy would be nice.

So how does one trade this market? This is a time to sit back and be grateful that you have an options background. Pure market direction traders are going to find the increased volatility more difficult to guess the direction of the trend, if one even exists anymore. But as options traders you have 4 more tools in your tool box. The most powerful tool you have is knowledge. Mr. And Mrs. Joe Average are stuck reading the cover of some magazine written by journalists too poor at trading, so they have to write for a living. They read an article by an English major at Desoto School for the Challenged and Engine Repair and hear the author loves MSFT, so they go out and buy the stock.

Instead, our readers prefer knowledge over tea leaves and recommendations by half-wits who soil the good name of "half-wits." You have 5 toys to play with instead of just one (delta). Let's review the different variables you can play:

• Delta – A bet on market direction alone. Either the underlying is going up or down, period. This is the hardest of all the variables to make a sound decision on. History has shown that the best are not right much more than 50% of the time.
• Gamma – A bet on the speed and extent or market movement in either direction. Playing gamma does not require you to be right on market direction, but rather just right that the market movement is going to increase or decrease in severity.
• Theta – This is a time decay bet. Since options are decaying assets one can make a bet on the world not ending and the clock always rotating at a constant speed. Of course, it is a little more difficult than that as a change in volatility and/or gamma can affect your theta bet.
• Vega – Ah, now for my favorite. Unless you are trading a butterfly or broken-wing-butterfly, any position you have on will have to have exposure to some greek risk in order to make money. Betting on vega is a gamble on whether or not the volatility of the market measure by the option prices will increase or decrease. This, for me, is the easiest of the greeks to be correct on as there are good historical numbers to go from and a mathematical function, called regression to the mean, working in your favor. Think of it this way: the VIX can be looked at as a stock that ranges between a 10 and 20%. When at 10 it is a buy and when at 20% it is a sell.
• Rho – This is a bet placed on the long term movement of interest rates and is best utilized via LEAPS options.

I am forbidden by many entities and three-lettered agencies from giving investment advice, so please do not act on what I am about to say, but rather consider this an education exercise. Hypothetically, if the market were to sell off again I would be looking to take advantage of things before, during and after as follows:

• A broken-wing butterfly strategically placed with the center strike at about Dow 12,000 (or the other index equivalent) would be a good strategic bet in my opinion. As David Letterman always says, "For entertainment only. Please, no wagering."
• Now that the VIX has sold off considerably from the top of the range, gamma scalping a long straddle may prove to be profitable. This one is a little dangerous. A couple things could go wrong. If the VIX falls hard without a corresponding and equivalent market move to justify a VIX move, offsetting the loss of theta and vega with scalps may not be able to be accomplished. If I were going to do this, I would play it close to the vest.
• If I woke from a coma today, more likely what I would be doing is rooting for another sell-off in the markets. I would hope the VIX got as high as +20% again and then I would figure out a way to strategically sell some volatility. Most likely I would sell wide straddle-strangle swaps, double diagonals, time spreads, etc. If I was more sophisticated, and I am not (preferring to use my sleeve over a napkin), I would sell index straddles and reverse gamma scalp to keep my gamma in line with my deltas.

I can't stress enough that I am not making any recommendations here whatsoever. This would be, however, a great time to learn new strategies by PAPER trading these ideas (not suggestions).  


Scott Kramer
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site
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