From the March 01, 2011 issue of Futures Magazine • Subscribe!

Using option risk reversal spreads

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.

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