We're now seeing the markets crumble. I anticipate a snap back at some point in the short term. This is also known as the dead cat bounce. It's way overdue and it's likely to be significant. Significant is a word that has different meanings based on volatility, but I anticipate that the Dow will reclaim 10,000 in the next month or so. Whether or not it will hold it is another matter. And of course, there is always the high likelihood that I'm wrong and we sink even further. So how can one play such a short term powerful boost but not risk a lot of capital? I submit the idea of an out-of-the-money long vertical spread. This isn't my favorite play in most circumstance because markets take time to move and OTM spreads have wicked theta. Of course, there's always a trade off, in return for having each day cost you, the OTM spreads are cheap. So if you're anticipating a big move fast, go out of the money to get more bang for your buck. But be warned, if the underlying doesn't move in your favor very quickly, you're a loser. That's right, even if the underlying moves nicely in your favor, theta will eat away your profit. The second problem to overcome is the current extreme readings on the VIX, which is represented as vega (option volatility). When the "relief" rally kicks in, vega will fall very quickly. A long option is long vega. The decrease in vega combined with theta will kill your option's value even though once again, we get a favorable move that happens quickly. This is where the vertical spread comes in.
(click to enlarge)
The illustration shows a 111/112 DEC SPY vertical. It is a measly .28 debit. However, the vertical red lines show the break even points. It's clear that over the next 30 days, theta will chew up a bit of our value, but it's not extreme by any means. The second thing worth noting though is our vega position. At the current price, we're long vega, but as the spread moves in our favor we become short vega. This mitigates quite a bit of our vega risk. So what's the catch? Well, by selling the 112 call, we've essentially capped our profit and significantly lowered our deltas. There's always a trade off! But with the greeks where we want them, we can gain additional exposure through more contracts.
Keep in mind though, this should be considered as a very short term play. If I were recommending this position (and I'm not) and furthermore if I decided to get into this position (I'm undecided at this point), I would likely stay in for a week, maybe two, tops. But if it moves significantly against me, I'll have considered myself wrong on the move and close out at a loss. This is why I've opted to go way OTM because I think the move will be fast.
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