V-Reversals and Legal Short Selling | Options Trading Strategies

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V-Reversals and Legal Short Selling

Friday, 19 September 2008 09:30 Written by John Jagerson

What we learned in options today:

The US government seems to be successfully turning the tide of investor sentiment in the stock market today. The Securities and Exchange Commission has taken the attitude that if you cannot convince the bears to become bulls then just ban them from participating in the market. The SEC did this by taking a very unusual step today of banning short selling on more than 799 stocks in the financial sector.

All of us option traders laugh "mwah ha ha ha ha!" (evil laughter) in the face of bans on short selling. In today's video we will talk about why shorting calls or even buying puts on the financial sector could be a good way to leverage the downside potential of the market without running into that pesky ban by the SEC.

From a technical perspective, What we are seeing right now in the market is beginning to look like a V-reversal. This is a technical reversal pattern characterized by its "V" shape. These are not uncommon in a fast downtrend but are inherently unstable. I think the fundamental factor that this rally is being artificially manipulated by the U.S. government only adds to the likelihood for a failure of this particular reversal pattern. The chart below illustrates this pattern as it is currently shaping up as well as another recent example near the first of the year.

S&P 500 Index Options (SPX)

Before considering a V-reversal valid I will typically want to see a break above a significant reversal zone. A break above resistance at 1300 (where the rising wedge of July-August terminated) would be reasonable confirmation in the short term that we may want to start considering exiting short positions or at least covering them. At this point, that will really comes down to investor confidence in the US government rather than the market itself. I am not optimistic that confidence like that is something that can be maintained for long.

It is interesting to note that no matter how short lived the rally may be it was accurately predicted by the extreme levels on the VIX on 9/15. As long as the VIX remains above 30 we are likely to have plenty of volatility in the market. You can see in the chart below that these spikes into that extreme sentiment area has been an accurate harbinger of short term bullish reversals for over a year now. This channeling behavior is normal for the VIX and can be used to forecast the market.

CBOE Volatility Index (VIX)

The drawback of a very high VIX reading is that option premiums are inflated. Shorting calls is an alternative to buying puts during market conditions like this but that does increase the risk per trade and may be unattractive to some options traders. It is worth noting that you can short the calls on some of these financial stocks that are banned from short sellers selling the stock itself. You can also buy puts on ETFs following the financial sectors themselves. Although these are aggressive trades, the opportunities for profits may be worth it if the market collapses back on itself in the short term.

- To learn more about ETFs click here.
- Here is another great article/video about small cap ETFs

Need help understanding market sentiment? Click here to see a great series of articles/videos on the VIX.

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