An Options Strategy for Trading Market Bottoms

How To Leverage Downturns With Reverse Calendar Spreads

Reviewed by Charles PottersReviewed by Charles Potters

Experienced investors look for ways to capitalize on potential rebounds as stock markets plummet. They often review their potential options strategies when doing so. Traders can craft positions with options to match almost any market outlook or risk tolerance, limiting their risk while positioning them for any upside. However, many traders are only familiar with options buying strategies, which aren’t the right tactic when there’s high volatility.

Market bottoms occur when a prolonged downtrend in stock prices reaches its lowest point before reversing. Identifying these bottoms is notoriously difficult, even for seasoned professionals. When a bottom is finally hit, the collapse in high-priced options following a sharp drop in implied volatility strips away much of the profit potential. So, even if you correctly time a market bottom, you’ll likely have little to no gain from a significant reversal.

However, the reverse calendar spread provides a way to potentially profit from a market rebound while mitigating downside risk. Below, we explore how the reverse calendar spread can be applied to trading market bottoms. We’ll examine the mechanics of this strategy, its potential benefits, and other major considerations to keep in mind.

What You Need to Know

• While timing market bottoms perfectly is very tricky, the reverse calendar spread allows investors to position themselves for a rebound with defined risk.
• The key to successfully implementing a reverse calendar spread during a market trough is understanding the mathematics of option pricing and the psychology driving market sentiment.
• The reverse calendar spread involves selling a near-term option and buying a longer-term option at the same strike price.
• Traders must carefully consider implied volatility skew and time decay when selecting specific option contracts.
• Proper position sizing and risk management are crucial when implementing this strategy during volatile market conditions.

Overview of Options Strategies

Before getting to the main strategy offered in this article, it’s best to set up why it’s well-suited for market bottoms compared with other options tactics. Options are financial contracts that give the buyer the right, but not the obligation, to buy (call options) or sell (put options) an underlying asset at a preset price (strike price) before a specific date (expiry). These derivatives give you a lot of flexibility to create widely different strategies for varied market situations.

Basic options strategies include buying calls or puts to speculate on price shifts, selling covered calls to generate income, and using protective puts to hedge against potential losses. More sophisticated strategies combine several options contracts to create specific risk-reward profiles.

Some popular options strategies include the following:

1. Bull call spread: Buying a call option while selling a higher-strike call option to cut costs, which limits potential gains.
2. Bear put spread: Buying a put option and selling a lower-strike put option to benefit from a decline in the underlying asset’s price.
3. Iron condor: Selling both a call spread and a put spread to profit from a range-bound market.
4. Butterfly spread: Combining bull and bear spreads with a standard middle strike to benefit from low volatility.
5. Straddle: Buying both a call and put at the same strike price to profit from significant price shifts in either direction.

The chart below includes buttons for looking at other popular options strategies:

Finding the Bottom

A market bottom occurs when a security or index reaches its lowest point before reversing and beginning its way back up. Identifying this crucial turning point is a challenging task even for experienced market participants. Several key characteristics often signal a potential market bottom:

1. Investor capitulation: This occurs when a large number of investors give up on the market and sell their holdings, often at a loss. This mass selling can create a “washout” effect, potentially setting the stage for a rebound.
2. Oversold technical indicators: Various technical indicators, such as the relative strength index (RSI) or the stochastic oscillator, may show very low readings, suggesting the market has been oversold.
3. Volatility spike: A sharp increase in market volatility, often measured by the U.S. Cboe Volatility Index, or VIX, frequently accompanies market bottoms.
4. Extreme bearish sentiment: Widespread pessimism among investors and analysts can be a contrarian indicator that the market may be nearing a bottom.
5. Positive divergences: Technical analysts look for instances when prices hit a new low, but momentum indicators fail to confirm it, potentially signaling waning downside momentum.

However, picking when the bottom has been found is notoriously difficult, even for savvy market technicians. This is where options strategies can provide a significant advantage. The reverse calendar spread strategy we’ll examine offers little or no downside risk, thus essentially eliminating the bottom-picking dilemma. This approach provides substantial profit if the market experiences a solid rally once the position is established.

In addition, this strategy offers an added dimension for profit through its exposure to volatility. Market bottoms often come with a sharp drop in implied volatility, typically occurring on a capitulation reversal day and during the following multiweek rally. The reverse calendar spread can profit from this volatility contraction by incorporating a short volatility (or short vega) component.

Warning

Even during severe bear markets, temporary rallies can occur, giving false hope of a true market bottom. These deceptive upticks are often called “dead cat bounces.” During the 2007-to-2009 financial crisis, the S&P 500 had six rallies of 5% or more before reaching its ultimate bottom in March 2009, thus demonstrating the difficulty of knowing when the market has finally bottomed out.

Shorting Vega

The VIX uses the implied volatilities of a wide range of S&P 500 Index options to show the market’s expectation of 30-day volatility. A high VIX means that options have become extremely expensive because of increased expected volatility, which gets priced into options. This presents a dilemma for buyers of options—whether of puts or calls—because the price of an option is so affected by implied volatility that it leaves traders long vega just when they should be short vega.

Vega measures how much an option price changes with a change in implied volatility. If, for instance, implied volatility drops to normal levels from extremes and the trader has long options (hence long vega), an option’s price can decline even if the underlying moves in the intended direction.

When there are high levels of implied volatility, selling options is, therefore, the preferred strategy, particularly because they can leave you short vega and thus able to profit from an imminent drop in implied volatility. However, implied volatility can still go up (especially if the market goes lower), leading to further losses.

Example of shorting vega

The assumptions for this simple hypothetical example are as follows:

• S&P 500 index value: 4,000
• Implied volatility: 35%
• Out-of-the-money call strike price: $4,300
• Expiration: 30 days
• Call option premium: $20 per contract
• Vega: 0.15 per contract
• Theta: $0.50 per day

The expectation is that volatility will decrease and the market will stabilize without rising above 4,300. Thus, 10 call contracts are sold with 30 days to expiration.

• $20,000 in premium is received from selling the options: 10 contracts × 100 shares × 20 = $20,000.

Suppose 10 days have passed and implied volatility drops to 30%. The decrease in implied volatility is 5% so the impact on the value of the trade is as follows:

• 0.15 × 5 × 100 shares = $750.

In addition, over those 10 days, the option undergoes time decay, known as theta:

• 5 × 100 × 10 = $5,000

Thus, over the 10 days, the total value gained from the short position in vega is $5,750.

Three-Day Rule

Many experts suggest following the “three-day rule” when confirming a market bottom. This is waiting three consecutive days of positive market performance before taking the bottom as established. While not foolproof, this can help filter out one-day wonders. Of course, those who wait won’t gain the profits of the preceding days.

Calendar Spreads

To capture the profit potential created by wild market reversals to the upside and the accompanying collapse in implied volatility from extreme highs, a reverse call calendar spread often works the best.

Normal calendar spreads are neutral strategies involving selling a near-term option and buying a longer-term option, usually at the same strike price. The idea is for the market to stay confined to a range so that the near-term option, which has a higher theta (the rate of time-value decay), will lose value more quickly than the long-term option.

Typically, the spread is written for a debit (maximum risk). However, another way to use calendar spreads is to reverse them: buying the near-term and selling the long-term, which works best when volatility is very high.

The reverse calendar spread is not neutral, generating a profit only if the underlying moves a lot in either direction. The risk is the possibility of the underlying going nowhere as the short-term option loses time value more quickly than the long-term option. This leads to a widening of the spread, which is the aim of the neutral calendar spreader.

Calendar Spread Example

In volatile market bottoms, the underlying is least likely to stay put in the near term. This is when reverse calendar spreads work well. There’s a lot of implied volatility to sell, which adds to the potential profits.

But suppose you expect the S&P 500 to stay relatively stable in the coming months and want to capitalize on this by implementing a call calendar spread. You carry out a call calendar spread using options on the S&P 500. Here’s the setup:

• Buy one S&P 500 Dec 850 call for a premium of $30 per share (total cost: $3,000, as each option contract controls 100 shares).
• Sell one S&P 500 Oct 850 call for a premium of $15 per share (total premium received: $1,500).
• Net cost (debit): The total cost of entering the trade is $1,500 (the difference between the premiums).

The calendar spread profits if the S&P 500 futures price remains near 850, as the shorter-term (October) call will decay faster than the longer-term (December) call, allowing you to potentially close the trade for a profit. Here are the possible outcomes:

If the S&P 500 stays around 850:

• The October 850 call expires worthless, while the December 850 call still holds significant value. You can close the trade for a profit, as the time decay on the short call worked in your favor.

If the S&P 500 rises above 850:

• Both the October and December calls will have value. You could face losses, given the value of the short October call, depending on how far the index rises.

If the S&P 500 falls below 850:

• Both options decrease in value. However, since this is a net debit trade, your maximum loss is limited to the initial cost ($1,500).

Reverse Calendar Spread Example

Now let’s see the reverse options calendar spread when you expect the S&P 500 index to be highly volatile over the next few months. Suppose you also think it will move significantly, either higher or lower, but you’re unsure of the direction. To profit from this expected volatility, you carry out a reverse call calendar spread using options on the S&P 500.

• Sell one S&P 500 Dec 850 call for a premium of $30 per share (premium received: $3,000).
• Buy one S&P 500 Oct 850 call for a premium of $15 per share (cost: $1,500).
• Net credit: You receive a net credit of $1,500 when entering the trade (the difference between the premiums).

This strategy profits from large price movements in either direction. The longer-term December call decays more slowly than the shorter-term October call, which means that if the S&P 500 moves significantly away from 850, you could close the position for a profit.

If the S&P 500 rises significantly above 850:

• The October 850 call increases in value more quickly, but the December call will also gain value, limiting your overall profit. However, the trade can still be profitable due to the time difference between the two options.

If the S&P 500 falls significantly below 850:

• The October 850 call will lose value rapidly, and while the December 850 call loses value as well, it does so more slowly. You can close the trade for a profit, as the value of the long October call drops faster than the short December call.

If the S&P 500 stays around 850:

• This is the worst-case scenario for the reverse calendar spread. Both options remain close to their initial value, and your maximum loss would be the net credit received ($1,500).

The strategy is directionally neutral but profits from volatility and large price swings.

Excluding Options, What Derivative Strategies Are there for Trading Market Bottoms?

Traders looking to capitalize on a market bottom can also use futures, swaps, and structured products. Futures spread trading, variance, and total return swaps, along with exchange-traded products, enable you to have leveraged exposure to profit from volatility changes.

How Do You Catch a Market Bottom?

Catching a market bottom requires a combination of technical, fundamental, and sentiment analysis, along with disciplined risk management. These tools could identify signs of a potential reversal. Traders often look for oversold conditions through the RSI, stochastic oscillator, and MACD, while searching for capitulation events marked by high volume and highly bearish sentiment.

Why Should You Trade Market Bottoms?

Trading market bottoms can offer significant profits because of the opportunity for strong price rallies, low prices, and favorable risk-reward ratios when the markets recover. Market bottoms often coincide with periods of fear, elevated volatility, and pessimism, allowing investors to buy high-quality assets at lower prices.

As volatility contracts and sentiment shifts, traders can capitalize on price rebounds, momentum, and policy interventions, especially through contrarian or long-term strategies.

The Bottom Line

Reverse calendar spreads are an excellent low-risk trading setup (provided you close the position before the expiration of the shorter-term option) with profit potential in both directions. This strategy, however, profits most from a market that is moving fast to the upside associated with collapsing implied volatility.

The ideal time for deploying reverse call calendar spreads is, therefore, at or following stock market capitulation, when huge underlying moves often occur relatively quickly. The strategy requires very little upfront capital, which makes it attractive to traders with smaller accounts. However, successful implementation requires a thorough understanding of options mechanics, careful contract selection, and diligent risk management.

Read the original article on Investopedia.