The S&P 500 is about 1% off of the all-time highs.  With that being said, there is a lot of concern that there may be a market pullback in the near future.  On the flipside, there is also reason to believe that the market can continue to go higher.  Since I am always one of the biggest bulls that I’ve ever met, I need to have a way to balance worries while still staying true to my overall market sentiment.

As I’ve said many times, I’m long term bullish and short term cautious.  At this point in time, I am concerned about a short-term pullback.  So, when I have such a concern, what can I do to help protect myself and my clients?  Let’s discuss.

As of today (SPX is about flat on the day as I write this), I do NOT want to sell any short term put spreads.  I like selling them when we actually get a market pullback and a bit of a pop in implied volatility.  I’m not saying that I would never do it on a positive or flat day, but it is not my preferred method.  This does not apply to selling puts on stocks that I would want to own.  That is an entirely different approach.  If I want to own a stock at a lower level and sell a put to get “paid to buy the stock”, I have a much lower concern about the specific market conditions that day.

The second thing that I like to avoid in markets like today is selling option premium too close to the money.  I don’t like selling ATM premium on either the call or put side if I’m concerned about a pullback.  The reason is that if we do have a pullback, a short call will likely not help me as much as I would like against the pullback, and it will hinder me a lot if we have a big run up.  A short put will have a similar risk/reward, but it will simply be the opposite.

So, what do I like to do in a market set up like this?  Since I’m never bearish, I won’t be going short in any way.  However, how can I be long and still have a limited risk?  I like buying an OTM call spread.  I like it because if the market goes down significantly, the only risk is the cost of the call spread.  If it goes up enough, the call spread can be very lucrative.  Of course, the only problem with this is the time decay involved.  Should the market go flat, time is working against you at all times.  As an investor, you need to be mindful of that and keep an eye on your trade.  Once it gets too close to expiration, run don’t walk to the nearest “close” button and get out of the trade. 

The other thing to mention is that an OTM call spread is something that should be bought with a smaller amount of capital.  I know what I like to see in an OTM call spread but understand that I only use a smaller amount of capital when buying options.  Don’t spend your entire net worth on an OTM option spread.  The benefit of it being right will make it so you won’t have to.  The drawback if you are wrong is minimal.  Once again, monitor time decay very closely.

If you would like to learn more about my services, please email me at mtosaw@rcmfs.com.