[The apex of yesterday’s 174-point short squeeze left our bearish option position (see below) undisturbed, since the put options we’d have exited on a 59-cent print traded no lower than 61 cents. When the flood tide receded, the puts rose to end the day at 81 cents. If DaBoyz should attempt to leverage Independence Day seasonality yet again, we’re prepared to blow out the position for a probable loss of $100, commissions included. RA]

A bearish option trade that we recently recommended in the Diamonds illustrates how Rick’s Picks attempts to establish short positions that are essentially riskless, or very nearly so, in a rampaging bull market. Last Tuesday, with DIA trading near 148.78, we told subscribers to buy put options if this popular trading vehicle, a proxy for the Dow Industrials, rallied to a Hidden Pivot target at 150.39. Here is the trading “tout” exactly as it went out to subscribers that night: The 150.39 rally target shown [click here] is a tempting spot to try shorting, since the ABC rally pattern has many characteristics that we like. Accordingly, I’ll recommend buying four July 146 puts if DIA trades above 150.35. Stop yourself out if the puts trade for 0.20 less than you paid for them. You could also offer 400 shares short at 150.37, stop 150.47.”

The 10-cent stop-loss we advised on the stock may seem extremely tight to experienced traders, but it turned out to have been a little wider than we needed; for in fact, the Diamonds peaked on Thursday’s opening bar at exactly 150.42, three cents above our target. This is shown in the chart above.  In the chat room moments later, several subscribers reported buying the puts for 0.79, so that is the price we used as a cost basis for our naked-short position. This is in accordance with our practice of using reports of actual fills rather than assuming subscribers got the best possible price.  At that point, we had a bearish bet down on the Diamonds that would produce a $400 gain if DIA fell to 144.21 come July 19, when the options expire. And below 144.21, we stood to make an additional $400 for each 1.00-point drop down to 142.

618-Point Drop Unlikely, but…

Keep in mind that a 1.00-point decline in DIA is equivalent to a 100-point drop in the DJIA. Thus, the blue chip average would have to fall by at least 618 points in the next 19 days to yield a profit.  Considering that the stock market until very recently has been on a bullish tear, that’s not a great bet.  It looks even worse when you consider that about 95% of all put options ever purchased have expired worthless. Indeed, in the nearly 40 years we have traded options, we have yet to meet a single trader on or off the exchange floor who has racked up gains over the years by buying put options.

So how did we justify the trade?  The key is that we don’t play it as an all-or-nothing bet. Most permabears tend to buy puts and sit on them until the options either dwindle to zero or produce a home run.  Our strategy falls somewhere in-between and entails, first of all, buying puts at just the right moment – i.e., when we expect the underlying stock to peak at a Hidden Pivot rally target. Then – and this is the important part – we look to spread off premium risk as soon as possible. How? In this case, as you can see, the Diamonds have fallen by the equivalent of 185 Dow points since we bought the July 146 puts.  This makes it possible for us to short puts of a lower strike against the ones we own for as much as, or even more than, we paid. Thus, if we are able to short-sell, say, June 142 puts for 0.82 – which is in fact our strategy at the moment – we would be left with a cost-free $4 vertical bear spread that has the potential to produce a position gain of as much as $1284 with no loss possible – not even a dime, after commissions, and even if the Dow should reverse and rocket 1000 points higher.

Of course, odds will always be against timing a market avalanche perfectly.  But the beauty of this strategy is that we can try it again and again with almost no risk. And if we are right just once in a blue moon, it will more than pay for the niggling losses, assuming a loss even occurs.

Selling at Thieves’ Prices

As of Friday, the Dow’s relapse had pushed the July 142 puts as high as 0.42, leaving us shy of our goal. However, if last week’s selling spills into this one, we stand a good chance of shorting four July 142 puts for slightly more than we paid for the July 146 puts, as we intend. Moreover, if the market does indeed open down on Monday morning, we’ll have a chance to sell the July 142 puts at the rip-off prices that are likely to prevail if market makers are forced to meet public demand for the puts from an avalanche of market orders executed at the bell.

If you’ve never made any money trading puts and calls and are curious about our risk-averse option strategies, click here for a free week’s trial subscription. For a more detailed description of the strategy subscribed above, click here to call up an article we wrote on the subject for Stock, Futures & Options magazine.