Yesterday the S&P 500 sold off over 1% and the VIX also sold off over 4%. Typically for a 1% down move in the S&P 500 the VIX will move up by 4%, so yesterday’s price action was very atypical and is a bullish indicator. The VIX moves up when the S&P moves down because traders bid up the cost of out of the money puts in order to protect their portfolios from further declines. Yesterday we saw traders doing the opposite: selling puts at levels they were willing to get long the market. The biggest trade of the day in SPY options was the sale of 48,000 Nov. 136 puts for $0.53 with SPY at 138.75. This trade will profit as long as SPY is above 135.47 (2.4% lower) at November expiration, which is in 8 days. If SPY is lower than 136 then the trader will be put to 4.8 million shares of SPY at 136, but regardless the trader will keep the $0.53 in premium collected.

For people who want to begin buying into this sell off selling puts is a good way to go because you can effectively get paid to lock in a price you are willing to buy at. However, selling puts means that you have all of the risk on the downside as a long stock position so you must be comfortable with the risks of owning the stock at the strike price. For people trying to pick a bottom in the S&P 500 but who don’t want to take delivery of the stock I recommend turning this trade into a put spread by buying a deep out of the money put as a hedge.

The case for keeping risk fixed and portfolios hedged is this chart, which overlays the price action around the 1987 crash with today’s market.

Though this doesn’t necessarily mean the market will crash today, it is important to remember that it could, and does so unpredictably. We are currently cautiously long the market with tightly hedged positions and are closely monitoring the S&p 500’s price action in the vicinity of the 200-day moving average.

Ahead of the open futures are down but off their lows, and given the options order flow yesterday I would be surprised if the market did not at least attempt to reverse some of yesterday’s sell off. Apple has been a great leading indicator of the overall market the past few months and in pre-market trading is up on the day and nearly $10 off its overnight lows, which coincided perfectly with a 50% Fibonacci retracement from its November ‘11 – October ’12 rally.