Question: How do you take advantage of a possible reversal while not fighting the overall trend?
Answer: Enter a risk reversal spread trade.
Unfortunately for traders, psychics cannot predict the stock market’s future. Instead, we are forced to use inaccurate tools, like Elliot Wave, MACD or even statistics to help us make trade decisions.
Yet, market participants often rely on such bromides as "The trend is your friend," and "Don’t fight the Fed." Markets also often make directional changes near key Dow numbers. That being said, where do you think the market will move next? A pullback or continued strength are equally viable options.
"Reversal of fortune" shows that the Dow hit a bottom at 10,000 and reversed higher at the start of September. At the beginning of November, the markets fell from 11,500 to 11,000, and bounced again. It is now (early February) retesting 12,000, and we must decide future market direction. For the sake of this article we will say that we are bearish because the U.S. dollar is getting pounded, the unrest in Egypt and the Mideast and the fact that the dollar has run up 2,000 Dow points in five months.
Assuming that the markets are nearing a temporary top, we could use traditionally risk-averse strategies and purchase a put spread or sell a call spread. Each spread has its own advantages and disadvantages, but if you combine them, their individual weaknesses are minimized and their strengths are supplemented.
Using DJX front-month options, we took the following option chain from when the Dow was just under 12,000 (11,990, or DJX of $119. 90). We can use DJX front-month options to create a short term bet that the market will make at least a small correction.
Suppose we wanted to buy the 117 – 116 put spread for $0.15 ($0.62 - $0.47). This would cost $0.15 per share or $150 for 10 contracts. If the stock went a little past 12,000, stayed where it was or even fell a little by expiration, then we would lose our total investment. Now, by selling an out-of-the-money 122 – 123 call spread at $0.18 ($0.38 - $0.20), we would take in more than enough money to offset the put spread investment.
The position combination of two spreads (117-116 put spread at $0.15 and 122-123 call spread at $0.18) sized out to 10 contracts will equate to a $30 net credit to our account. This should go a long way toward offsetting the commission costs.
There are 16 trading days remaining until expiration and the implied volatility of the options is roughly 13.6%. We can, therefore, expect the stock to have a one sigma range of about $4.10 (or about 2.05 in either direction of the current price of $119.90). Consequently, the position’s expected range and PNL is relatively safe to the upside and has a realistic chance of making money to the downside. A normal distribution curve (Gaussian Curve) of the DJX index shows the position is fairly safe because its upside risk area is at or outside the statistical one-sigma-range for the underlying’s expected move. The downside is similar in appearance (see below).
We need the market to close below $116 on expiration to maximize the full potential of this spread. However, if the market has reached its top and the mean shifts lower (as expected in our opinion), then it’s alright for our long put spread to have a statistically "fair" chance of coming into its own.
This position is not for everyone, and it does carry some risk if you are wrong. Yet, many traders consider it vastly superior to shorting stock, purchasing a long put, or selling a short call by itself. As long as the stock closes between the strikes (117 put, 122 call), we still will keep our $30 initial credit. This obviously would not happen with just a long put spread position. That being said, we still prefer a long broken wing butterfly spread.
Edward LaPorte works with Random Walk, LLC., an education company that designs creative solutions to any market opinion. Their website is: RandomWalkTrading.com.