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

Using option risk reversal spreads

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.

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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.

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