From the February 01, 2009 issue of Futures Magazine • Subscribe!

Options strategies for an overshot market

Question: You believe a market has overshot and is in Bubble Land. How do you profit without incurring too much risk if your timing is off?

Answer: Try one of these three options strategies.

The exponential rise in Treasuries at the end of the year foretold a correction, possibly as violent as the move up (as of press time, U.S. Treasury bond futures corrected nine handles from their all-time high). There are several option strategies that can be used to keep your risk limited while leaving you profit potential, if the bond market does collapse. Each strategy has its pros and cons, therefore one strategy may be more appropriate than another depending on the investor.

The first thing that an investor needs to do is decide how low they think Treasury bonds (or whatever market) could go and when it is likely to reverse. Once you have decided on a time and how large of a correction to expect, you can select the proper option strategy.

The simplest strategy is to buy at-the-money puts. For example, on Dec. 31, the 30-year Treasury bonds closed at 138-01. You could have bought the March 138 put 51 days until expiration for $4,125. With this strategy, your risk is limited to what you invest, while leaving your profit potential open. The market needs to move substantially but not unreasonably given the run-up for you to be profitable. Your breakeven on this trade would be 133-28. If bonds go to 130 in 51 days, you would be up $3,875 per contract. On the downside, it doesn’t seem to make much sense to pay more than $4,000 and receive no value other than time. Why not just sell the future with a wide stop? In this scenario you would expect a huge correction in short order (as what actually happened) and you are protected if you are a blow-off day or two from the top. If it doesn’t correct sharply, as it did in this case, you could get out 30 days or more prior to expiration when the time decay begins to speed up.

Another strategy is to buy deep out-of-the-money options for less money. This strategy is like trying to hit a home run. For example, if you bought the March 125 puts on Dec. 31 you would pay roughly 53/64 or $828.12 each. You would employ this strategy if you believe the bonds will sell off hard within the next month. If you bought five March 125 puts for a total cost of $4,141, roughly the same cost as the at-the-money put, and the market goes to 130 in 14 days, these options will theoretically be worth $1968.75 each. That would make all five options worth a total of $9,843.75. If the market does drop dramatically like a traditional bubble bursting, these will work out better. For example, if in 20 days the bond market is trading at 125, these five options will be theoretically worth just over $18,000, while the one 138 put will be worth roughly $14,000.

You can see the benefit of buying far out-of-the-money puts, but there is also a downside. If the market moves slowly and not in a major way, these 125 puts will expire worthless and you will lose your initial investment. You can risk less and require a more dramatic move to profit. This is not a strategy to build a trading career on, but one that attempts to take advantage of a rare situation. However, there have been several examples recently where this may have been appropriate: crude oil, equity indexes and perhaps Treasuries and there will probably be more during the current economic upheaval.

The final strategy is to buy a vertical bear put spread. The first strike will be at a level you think the bonds will fall below substantially and the second strike will be at a level of support. This strategy allows you to moderate the cost of the put by selling a further-out put. This limits your potential profit to the difference between strike prices. For example, you buy the March 138 put for $4,125 and sell the March 131 put at $1,703. Your cost would drop from $4,125 to $2,422, not including commissions.

The most this spread could be worth is $7,000, with a maximum risk of $2,422, a near 3:1 risk/reward ratio, if bonds settle below 131. If bonds settle at 134, this spread would be worth $4,000, because the short 131 puts would be out of the money, while the long 138 puts would be worth $4,000 each. You can fine tune this strategy to increase potential, or reduce cost. When doing a vertical spread you should look for a 3:1 risk/reward ratio or better.

We have seen some dramatic moves in the last year. Options allow you to tailor a strategy to a specific event allowing you greater profits on limited risk, if you are right.

Frank D. Cholly and Frank J. Cholly are both senior market strategists at Lind-Waldock. E-mail them at fdcholly@lind-waldock.com and fcholly@lind-waldock.com

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