Why This Investment Strategy Thrives During Market Flash-Crashes
by Karim Rahemtulla, Investment U’s Options Expert
Tuesday, March 29, 2011: Issue #1479
What would you do if the stock market suddenly dived by 10% in one trading session?
How about 16%?
Such “flash-crash” events aren’t entirely out of the question. They happened in the United States last year and in Japan a few days ago.
In fact, they’re becoming more frequent.
That’s why you need an investment strategy to deal with them. Because if you’re unprepared, the speed and force of the move can pummel your holdings. If you are prepared, however, they also provide unbelievable opportunities.
And there’s no time like the present to implement such a strategy…
When the Flash Crash Hits… Sell (But Make Sure You Do it This Way)
The best strategy to use to guard against a flash crash is one that involves put options.
I’m not talking about buying put options – that won’t work since the crashes are too quick to make money on them, unless you’ve bought an option the day before and sold it during the crash – an unlikely occurrence.
No, I’m referring to selling put options.
When you sell a put option on a stock, you receive cash immediately in your trading account. In return, you obligate yourself to buying the shares at the strike price you selected.
Here’s why this works so well during a flash crash…
When the market tanks, all options premiums increase rapidly – and especially those on put options. That’s because buyers and sellers don’t know if the fall is the beginning of a wider correction, or a one-off crash.
Not even the Black-Scholes options pricing model can anticipate whether a crash is going to be short-lived or not. Therefore, the pricing plays to the sellers’ advantage, since the premiums increase substantially. When volatility kicks in, options prices move higher fast, often to a greater degree than the underlying share price. This occurs since options are creatures of time.
Selling Put Options On Companies You Want to Own
So this is what you need to do:
- First, make sure you have permission to sell puts. This requires a higher clearance than more basic strategies like trading covered calls, for example.
- Make a list of companies that you’d like to own at the price you want to pay. Preferably, that price will be 30% to 40% lower than the current price of the shares. For example, if you like a stock at $40, you may really like it at $25. You can enter a limit price at which you’re comfortable selling the $25 put – maybe for $1 or $1.50. If the shares slump during a crash, you may get filled at your price, before the stock subsequently recovers. But remember the cardinal rule of put selling: Only sell puts on shares of companies that you want to own!
- Be sure you have the capital required to pay for the shares if you end up being obligated to buy them.
- And remember, the shares don’t have to hit your price to make a lot of money… they just have to head in the direction of your price.
Put-selling is a very effective way of generating income and also building a potential portfolio of stocks at much better prices than they’re trading for today. You owe it to yourself to spend some time learning how to sell puts – it could be the most profitable option in a volatile market.
About Karim Rahemtulla
With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.