Question: How do you improve your odds in a bear spread position?
Answer: Add a naked leg to reduce your initial cost
Due to the explosion of volatility, normal position trading strategies using any type of standard risk management have been hard pressed to show positive results and this has been especially evident in currencies.
The normal risk bands seem to have quadrupled. However, increased risk usually equals an increased reward. We need to adjust our approach to the market, so we can stand the heat while we look for the reward.
Let’s look at a current example in the Japanese yen. After recognizing a possible double top, Dec. 17 and Jan. 21, we wanted to get short. However, selling the yen on Jan. 26 only gives us two options using standard risk management; the last high (second leg of the double top) of 1.1496, a risk of more than $3,000 (close of 1.1250). Our second choice would be the high from three days prior, 1.1382, or a risk of almost $2,000.
This type of risk, although uncomfortable, is not unusual. But there is also the risk the market will retest the high or worse experience a blow-off top where our stops get run through by a point or more. There is nothing worse to a trader than losing on a trade due to a miscalculated placement of a stop loss.
Our downside target is the 106 level based on the Jan. 6 low, which came between the recent highs. That low and the double top around 1.1500 set the near-term trading range; an $11,000 range over the last 26 days.
Simply going short the yen gives us too much exposure. We need to soften the volatility, so that we can not only sleep at night, but also survive the day-to-day slice and dice. This is made possible with the creation of a synthetic futures spread, where we use an option strategy that would help us achieve our trading goals with a greater degree of comfort by turning down the volatility without forsaking the upside of a “plain vanilla” long option strategy like buying a straight put.
The March 110 put on Jan. 25 would cost approximately $2,537.50 before transaction costs. That means that the intrinsic break-even would be about 1.0797 without transaction costs. Considering that the market closed at 1.1272, and compared to just selling a futures contract with a stop loss at the recent high, buying the option has a risk that is comparable to a short futures contract without the reward probability. This is due to the delta factor and because the spread between your strike and the market already puts you $3,000 in the hole. We then consider selling a covered put to lessen not only our cost but also the intrinsic break-even spread. The 106 put (our downside target) is selling for about $960, which would give the trade an overall risk of about $1,600 without transaction costs and an intrinsic profit potential of roughly $3,400, or a little bit better than a two-to-one return on risk. Not bad, but we are still starting in a hole.
By selling an additional call option above the market, we can skew many of the odds that plague both futures and options traders alike. Selecting the strike is most important and involves looking at the premium collected and the course of the underlying market. After analyzing the charts and the call option premium in comparison to the market and the premium of the puts, we get an idea that calls are overpriced.
Technicals show a possibility the market will move higher and perhaps break through the double top and reach 120. However, the downside is more probable, so we choose the 120 call as the naked leg we sell and collect an additional $1900, which turns our bear put spread into a bear put spread with a naked leg, at a credit of $300 not including transaction costs.
We now have unlimited risk. If the market does go above 120, we are short the futures with a cushion of the excess premium collected, but the addition of the short call skews the odds a trader normally faces into our favor.
In this case, if the market goes down the trade will work; if the market goes sideways the trade would still be profitable due to the credit collected, and last, if the market goes up we could still be profitable as long as it doesn’t finish above our short 120 call. Best of all, as the market goes through its day-to-day volatility swings where a futures trader would be suffering the nail biting draw downs, we are not affected as much because of the sponge-like effect the short put has with the short call.
Paul Brittain is branch manager of Alaron Las Vegas. He wrote the book “Commodity Options: Trading and Hedging Volatility in the World’s Most Lucrative Market” (FT Press) with Carley Garner.
