by Peter McKenna
Imagine that you are an event trader and all the conditions for a Green Alert Day have been met. Day after day, sellers have dominated in the trading action, driving the market to greatly oversold levels. Recent economic indicators have been negative, which means the economy is crawling along. The only positive for the market is that, at the moment, tensions around the world have subsided. There is no nagging uncertainty to keep investors at the sidelines.
Now imagine that before the bell, Microsoft announces spectacular earnings and says its future earnings appear strong as well. A Green Alert day might unfold before your eyes. The market is oversold and there are no prevailing conflicts or uncertainties. The market will very likely go up, perhaps way up. It is time for you to act, to jump into an index call option.
Green Alert Days
When the conditions necessary to create an Upside Green Alert Day occur, don’t hold back. Take the risk with Nasdaq 100 contracts. To make the most of the leverage provided by options, buy as many Nasdaq 100 contracts as you can afford.
Picking Strike Price & Expiration
Let’s say that you do not expect the Nasdaq 100 Index, currently at 1025, to come anywhere near the strike price of 1,125, which is 100 points away. But the 1,030 contract is just slightly out-of-the-money. You will get the $0.50 rise for every point rise in the index and the options are not as expensive as the in-the-money contracts. This means you can buy more contracts. If the index goes up 45 points, the contract price will go up $22.50. Each of your contracts will be worth $54.50, or $5,450 per contract. If you bought seven contracts at $3,200 each and sold them for $5,450 each, you would have a profit of $2,250 per contract, or $15,750.
You have risked nearly all of your available capital on the potential for a Green Alert day. It is absolutely imperative that you protect this investment by using a stop loss order. Enter the trade using a stop-loss limit of 10% of the per contract price. Ten percent of $3,200 is $320, which sets your stop loss at $28.80. If the contract price drops to this level, the seven contracts will be sold automatically. Your loss would be $320 per contract, or $2,240.
This is a reasonable risk to take when the conditions for a Green Alert Day hit the market. But this is the only time you should take a risk of this magnitude.
Yellow Alert Days
Let’s assume that Microsoft has stunned the market with stellar earnings. But there is great uncertainty in the market. Will Microsoft’s news be strong enough to overcome this uncertainty? It might, and it might not. The important element for you as an event trader is that this day is now a Yellow Alert day, not a Green Alert day.
This means the yellow caution flag is up. Use a strategy that is the reverse of the one used on the Green Alert day. This means staying away from the volatility of the Nasdaq 100 contracts, buying at-the-money instead of out-of-the-money and going further out than the expiration. It also means buying fewer contracts and setting a stop loss limit of 5% of the price of one contract, not 10%.
I would buy an S&P 500, S&P 100 or Dow Jones contract to lessen the volatility, but I would not buy the QQQ contracts. These contracts, with less than a 50% delta, move too slowly for me. My personal choice is the S&P 500; I trade these contracts more often than the others. In the scenario above, I would have purchased two 1025 calls, at a price of $11.00, or $1,100 per contract, with a 5% stop loss limit. My total exposure to the market would be $2,400, instead of $22,400 in the Green Alert scenario above. If the 5% stop loss limit was triggered, I would lose just $110.
The extreme difference between the risks taken on a Green Alert day and Yellow Alert day stem from the respect you must have for the market’s tendency to do the opposite of what you expect at any given moment. Too many investors have learned the hard way that stock prices can turn against them at any time, particularly when the market is filled with uncertainty.
As options get close to expiration on the third Friday of every month, their prices drop dramatically. When a Green or Yellow Alert Day occurs while options prices are low, event traders have a rare opportunity to greatly maximize profits by purchasing a large number of cheap contracts.
The serendipitous occurrence does not happen often. But if you find yourself facing such a situation, follow the guidelines below.
Imagine that it is the Monday before expiration and a downside Green Alert day is possible. The market has been running up for weeks, there has been little uncertainty, and earnings results have been good. Then a double dose of bad news hits the market. A large company reports terrible earnings and there are rumors that the US is getting ready to invade Iraq. Suddenly, uncertainty is running rampant.
You check the prices of puts on the S&P 500 that are due to expire on Friday. The index is trading at 1025. The 1025 put just a week ago was priced at $15.00, or $1,500 per contract. Now it’s $1.50, or $150 per contract. With $25,000 in capital, you can buy more than 160 contracts. Because it’s so close to expiration, the value of your at-the-money contracts will not gain at a full 50% delta, but they will go up nonetheless. If you get just a $1 rise in the contract price, from $1.50 to $2.50, you will make $16,000.
Take a deep breath and remember the following: This is indeed a good opportunity to make a large gain. But it is also risky. There is no guarantee that the market will slump dramatically. It may, and it may not. Traders may sit on the sidelines, waiting for confirmation of the rumored invasion. Or they may panic and sell with abandon. You have to make a quick decision based on your reading of the enormity of the news.
In the case above, I would take the plunge. I would buy the contracts and watch the S&P 500 carefully. The earnings news by itself is likely to drive the market down from its lofty heights. But I would set a limit on the price of the contracts I had purchased. If I got a %0.50 rise in the contract price, or a profit of $8,000, I would immediately sell. I think of the situation above as a gift that is offered for a few minutes on a one-time-only basis. It’s best to take the gift and move on, rather than holding out for a huge windfall and risk losing a great amount of your capital.