Strategy Breakthrough?

DIA Hedges Balance Out Headline Risk

By Bryan Bottarelli
Thursday, March 13, 2008 2:40 PM EDT
Thu, 13 Mar 2008 18:40:00 GMT

Dear Bottarelli Research Member,

I think we may have hit on a critical strategy breakthrough with how we managed today’s trading tactics. But before I explain any further, let me take a quick moment to discuss the current status of the market.

In my trading experience, the most difficult market periods come at the major turnaround points. For example, 80% to 90% of the time, the major market averages are trading within the parameters of some trend — either up or down. The other 10% of the time, the major market averages are “deciding” whether or not to extend upon their current trends — or to transition over into a new trend. These “decision-points” are where we historically experience the most choppy and volatile market action — and that’s exactly what we’re faced with right now.

As I write, the Dow is trying to decide if the January 2008 low is a support point or a breakdown point. Whatever the outcome, options traders (like us) will know how to make money. We’ll either play puts if a new down-trend emerges or we’ll play calls if the continuation of the up-trend emerges. It’s really as simple as that. But until the markets decide their next major directional move, we’re faced with a market that’s prone to “headline risk.”

For example, Tuesday’s 400-point market rally was not technically-driven. It was sparked by actions of the Fed. On the same hand, this morning’s 200-point nose-dive was not technically-driven. It was sparked by the overnight news that Carlyle Capital may be on verge of collapse. And even more recently, this afternoon’s recovery was sparked by S&P saying that the bank write-downs might be behind us!

Faced with a market that’s dominated by headline risk, how do you play it? That’s a tricky answer, but I think we may have cracked the code using our trading strategy from yesterday afternoon and into today.

You see, coming into this morning, we were holding calls on APA, BG, and FCX. And just as a level of safety, we also held a put position on the Dow Diamonds (DIA). This gave us a long position in strong sectors like commodities (via BG), energy (via APA) and metals (via FCX). And it also offered us a safety net against a major market sell-off.

As it turns out, we did see a market sell-off this morning, as the Dow gapped down 200 points at the open. As a result, our BG calls got clobbered. But luckily, our DIA puts offset these BG call losses. And what’s more, APA and FCX did a remarkable job of holding their ground in the midst of the selling pressure. Therefore, we effectively maintained a long position by holding calls on APA and FCX while the gains on our DIA puts and cancelled out losses on our BG calls. And then, as the morning turned into afternoon, the markets recovered all of their 200-point losses and traded nearly 100 points higher. Thanks to this 300-point turnaround, we’re now in position to lock in gains on our APA and FCX calls! In a market like this, I think that this strategy of balancing calls on strong companies (dictated by my standard trading triggers) with DIA put hedges might be the best way to handle our trading going forward. For one, it gives us the freedom to add calls without worrying about headline risk. Two, it allows us eliminate our quick sniper-selling tactic, which helps positions run higher and maximizes profits. And three, it works to negate the intense intra-day price swings that we’ve seen recently in the day to day markets.

Going forward, I will continue to explore this trading tactic — with the hopes of producing even stronger (and more consistent) returns despite the increasingly volatile market conditions. In the meantime, maintain your APA and FCX positions. And as always…

Lock and load!

Sincerely,

Bryan Bottarelli

Bryan Bottarelli
Editor, Bottarelli Research

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