Options Theory: The Knife Catch

Trade war antics continue to haunt the Street, but the pain hasn’t been meted out equally. One of the hardest hit areas is emerging markets. Though, its suffering has been exacerbated by the recent muscle-flexing by the U.S. dollar.

With the iShares Emerging Markets ETF (EEM) now reaching deeply oversold territory, my inner contrarian is beginning to growl. Catching falling knives isn’t an activity for the faint of heart, but it’s an activity that I like to engage time to time. Today I’ll show you how.

I call this particular strategy The Knife Catch. The ideal setup is to find a stock or ETF that is reaching oversold territory with higher implied volatility. It’s even better if it’s a security you’re long-term bullish on and have been waiting to take a bite at a discount.

Take a gander at the EEM chart below. Would you say it qualifies as oversold? The stochastic indicator certainly says so. And what of the implied volatility rank? It has been on the rise, eclipsing the 50th percentile just yesterday for the first time since April.

Oversold stock? Check!

High implied volatility rank? Check!

By darn near any definition, the current posture of EEM qualifies as a falling knife. The next piece is to identify the trigger. We’re going to deploy a bullish trade so we want some confirmation that buyers are finally starting to swarm. There’s no sense in plowing in now if EEM is going to drop for another few days.We can use a break of the prior day’s high or at least intraday resistance.

Now, for the strategy selection, well, this is where things get interesting. I much prefer doing a high probability play such as selling OTM puts instead of buying calls or call spreads for a few reasons.

First, it provides a large margin of error in case EEM fals a bit further before finally snapping back. This wider profit range decreases the chance that we get shaken out before our original forecast proves true.

Second, selling options capitalizes on the high implied volatility rank. The increased level of panic is inflating OTM puts making them ripe for the selling.

Third, the nature of our bet can be thought of as follows. We’re not so much betting that EEM will rally aggressively from here as much as we’re wagering it simply won’t fall as much as expected moving forward.

Instead of entering our entire position at once, this is a perfect scenario for using the scaling-in tactic. We will begin with a starter position that we can add to if EEM slides further in the coming days.

Currently the Aug $40 call is trading for 55 cents and has a 25 delta. Suppose that’s the strike we want to play with. By the way, EEM peaked at $52.08 in January so a drop to $40 represents a 23% decline. Basically, we’re obligating ourselve to buy the stock at a pretty hefty discount to its prior peak.

Here’s another way to look at the setup. EEM’s current downswing began at $47.15. At its current perch of $42, it’s already slid 11% unintterupted. A further decline to $40 would be a 15% decline without any type of snap-back. I’m willing to bet it sees at least a modest attempt at a bounce sometime between here and there. That’s where this naked put trade will rake in the dough.

Suppose EEM starts to rise today (thus far it hasn’t) and we pull the trigger on our short Aug $40 put at 55 cents. If we get a big enough pop and can buy back the put around 20 cents quickly we will.

If EEM slips further we’ll look to add a second tier around 80 cents and a third tier at $1.10. Since we captured a greater premium on the second two tiers, we can exit quicker on the bounce. Here’s how I would view this trade

Tier 1: Enter at 55 cents, exit at 20 cents.

Tier 2: Enter at 80 cents, exit at 40 cents.

Tier 3: Enter at $1.10, exit at 70 cents.

If EEM continues plumbing the depths and we end up holding all three tiers into expiration then we have two choices.

First, allow assignment and purchase 300 shares at an effective purchase price of $39.19. Then sell covered calls until you recoup your loss.

Second, roll the three naked puts out to September to extend the duration of the trade and give EEM a month to recover.