Wednesday, May 19, 2010

Time to Catch a Falling Knife?

Careful with the song... it's addicting.

And for those of you LOST fans out there, here's the more ominous, eerie rendition from this season's "Sundown" episode.

So you want an example of a falling knife? How about oil over the past month... yowza. It's sliced through multiple support levels like butter. Nothing like a 20% drop to smack the complacency out of the bulls. At it's current position simply saying it's oversold is like saying Michael Moore is chubby. An understatement to say the least... It's overstretched based on virtually any measurement- stochastic, RSI, bollinger bands, et. al. But, might today's price action finally be pointing towards some exhaustion? In addition to the extremely oversold nature, we've also got high volume bordering on climactic and a strong bullish reversal candle. Admittedly, trying to catch a falling knife is not for the faint of heart and can be very difficult. Were I to stick my neck out and try it, here's a few things I'd consider...

Due to the severity of the sell-off, implied vol is not surprisingly through the roof. In addition, the volatility skew of downside puts is quite pronounced making them a tempting short. The beauty of shorting OTM puts or put spreads versus buying stock when betting on a bounce is the fact that you have a bit of a buffer before reaching your expiration break even. You're also positioning yourself to profit from a drop in implied volatility which will likely occur if the stock pops. Consider the risk graph of a July 30-27 put spread:

[Source: MachTrader]

Since there's always the off chance that this oil sell-off turns into a 2008 rip the head off the bulls style free-fall, I would be very judicious in my position sizing. Keep in mind one of the easiest ways to manage risk is by keeping positions small.

Addendum: I penned this post yesterday, so today's gap down pretty much negates the potential signs of a bottom in yesterday's price action. I'd wait for the smoke to clear and reassess before doing anything with USO.

For related posts, readers can check out:
Naked Puts vs. Put Spreads
Rolling with Crude Oil


MarkWolfinger said...

I remember the Perry Como version (1957; from before you were born.


Tyler Craig said...

Nice. I actually listened to his version on Youtube, but liked the Nina Wall version better. Definitely before my time... lol.