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With financial markets taking a hit last week, there are differing viewpoints on where we go from here. We ran through some technical levels on SPY late last week, with both near term support and resistance. For investors that are unsure on the future direction of markets (but have exposure), options trading can be a good tool to both protect a portfolio but also look to profit from high volatility. Here are our favourite plays right now.

Buying straddles

Calling the right side of the market is tricky, calling volatility is slightly easier. Over the next few months, we think that volatility on the main indices is likely to stay elevated. Therefore, one strategy we like is to buy a straddle with a three month tenor (or closest quarter expiry). Straddles are a structure whereby you buy both a call and a put option with the same strike and the same expiry. 

In this way, you pay both premiums upfront, but if you see a large move either higher or lower, the trade becomes profitable. In essence, it’s a volatility play rather than a directional one. As long as you see a large enough move in either direction from the original strike, it can generate an option trader money.

The risk here is that volatility decreases, and any main stock index finds a range in coming months. In this case, the loss would amount to the premium paid. Your time value (theta) would also be eroded if you don’t’ see a move anytime soon.

Puts protecting downside

A more straightforward options trading idea would be to buy puts on the stock owned within a portfolio. If there’s concern about a stock market crash taking particular shares significantly lower, then buying puts could be a good idea.

This primarily acts as a hedge, in that I’d still own the underlying asset but would benefit from a move lower when the put becomes profitable. There are a few points to note here. Firstly, what size of exposure do I want on the put? I can always put 2x the notional on the put to try and generate a higher level of profit if I really think the stock is due to fall. Secondly, what strike should I take? Naturally, the further (lower) away from the current market price, the cheaper it’ll be to buy this protection.

Selling calls

The final idea would be to sell calls that are out of the money. This means I’d be picking up the premium, which can act as income. To reduce my risk here, I can just sell calls on stocks that I already own. That why, I can easily deliver the shares on expiry, and would be selling them likely at a profit.

Writing uncovered calls carries with it a much higher risk, as in theory my loss could be unlimited. This is something I’d need to weigh up, depending on how bearish I am on the particular index or stock.

Overall, the above three options trading ideas should hopefully be able to give me some direction on how best to navigate a potential stock market crash.

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