Question: How do I profit from an anticipated market reversal without the risk of attempting to catch the proverbial falling knife?
Answer: The call ratio backspread
Major market bottoms often are difficult to identify as they unfold. Trading turning points is challenging because market bottoms often occur when sentiment is poor and the headlines are screaming “sell!” Playing the role of contrarian in this environment isn’t easy. It’s one thing to identify a market bottom after the fact, it is quite another to put money on the line against the current trend. Fortunately, with options, there are relatively low-risk plays to profit from the reversal in the long-term trend. The call ratio backspread is one of them. As the housing bubble began to burst more than a year ago, the homebuilder sector has come under pressure. Since its inception in February 2006 until the end of 2007, the SPDR Homebuilders Fund is down 53%. Trading under the symbol XHB, this exchange-traded fund (ETF) holds shares in 21 different companies involved in homebuilding.
Given the awful headlines, it might seem premature to bet on a rebound in shares of housing or homebuilding companies, yet there is a chance that share prices will begin to rebound before the headlines improve. The stock market is forward-looking and tends to discount events before they happen. Also, with the Fed aggressively lowering rates and the government offering tax rebates, there is a chance that the worst is over. The risk of buying shares, however, is that the problems in the industry create a chance of bankruptcy within the sector.
Rather than bottom fishing among the individual homebuilders, you might consider trading the SPDR Homebuilders Trust. The fund holds 21 companies and adds an element of diversification. In addition, since options also are available on the XHB, you can create a number of different risk-reward strategies. Simply buying shares and owning puts, for example, would greatly reduce the risk of buying shares alone.
A strategy that profits from a long-term trend reversal is the call ratio backspread. This trade is created by selling calls and buying a greater number of calls with a higher strike price, normally in a ratio of .67 or less. Using the XHB as an example, you can sell two at-the-money calls and buy three out-of-the-money calls (a ratio of 3-to-2 equals .667).
In this example, the XHB sits at $21.50 a share on Jan. 29. It is already up 41.3% since Jan. 9 and you expect more volatility throughout the rest of 2008. So, a call ratio backspread is created by selling two Sept. 22 call options for $3.75 and buying three Sept. 25 calls for $2.25. Since the 22 calls yield more premium than the cost of the 25s, the result is a credit equal to $75 for each backspread, or ($3.75 x 2 - $2.25 x 3) x 100. Since both sets of calls are out-of-the-money, if XHB fails to move higher by September 2008, the calls will expire worthless and you keep the credit for creating this backspread.
On the other hand, the best percentage gains occur if the XHB makes a significant move higher. “Betting with the backspread” shows the recent price action in the SPDR Homebuilders Trust (left) and the risk graph of the backspread (right). If the fund immediately moves higher (red line) with 234 days left until expiration, the trade begins to show profits almost immediately.
Ideally, the fund will move above $30 per share between the time the trade is initiated and options expiration in September. That is a big move, a 39.5% gain. Keep in mind, however, that shares rose 41.3% from Jan. 9 to Jan. 29, or in less than three weeks time. It is clearly capable of big volatile moves.
Some critics of the backspread point out that it loses money before it makes money. They don’t like it for that reason. Importantly, however, this strategy is designed as a play on a long-term trend reversal. It will deliver large percentage gains in the event of a major advance, but also will generate income in the event that the bottom really isn’t in yet.
Frederic Ruffy is a senior writer and trading strategist for Optionetics. He can be reached on his message board at www.optionetics.com
