Options spread that locks in your risk

December 31, 2011 06:00 PM
Options Strategy

Question: How can you take advantage of a sure thing, when you are not sure of the timing and volatility?

Answer: Execute an options spread that locks in your risk.

Some market moves can be predicted easily in the long run but can’t be exploited because of short-term volatility. Seeing the opportunity in front of your nose is not enough to profit from it — you also have to know how to trade it.

Traders expected that the Gulf War (I) would have a dramatic but probably short-term impact on crude oil prices in January of 1991. Apple likely would skyrocket once Steve Jobs came back as CEO, and interest rates obviously would be lowered during the 2008 banking crisis.

Some events are easy to spot but not easy to exploit. The best example is the Tech Bubble of 1997-2000. It left many astute traders bankrupt as they shorted stocks prematurely and couldn’t hold on for the inevitable turn. Imagine shorting AMZN at $211 on Nov. 30, 1999 and seeing it trade at $477 on Jan. 3, 34 days later. A position short100 shares would have cost $26,600.

Could you have held out another year until Dec. 19, 2000, when the stock got down to $28? Not on a naked short. Being long or short stocks can have unlimited losses if you are wrong, yet a strategically executed option strategy can predetermine acceptable risk characteristics for a specific time frame.

Even casual observers of mortgage rates and the U.S. government’s interest rates can see that these rates likely have hit a bottom and eventually will rise. Standard & Poor’s rating agency has downgraded U.S. government debt once and they and other ratings agencies are considering a further downgrade. While U.S. Treasuries sloughed it off the first time, that is not likely to continue. If the economy is indeed coming out of its stagflation period as many believe, then raising interest rates will be one of the first tools that the Federal Reserve will use to stave off inflation.

The 10-year Treasury note is yielding less than 2%, which translates to an all-time high in prices. The Federal Reserve has maintained a zero interest rate policy since late 2008 and though its "Operation Twist" is attempting to keep yields down on the long end of the curve, it is running out of bullets. For these reasons, the likelihood that rates will move higher in the future is strong. But you could have said the same thing a year ago and would have been wrong, similar to the Tech Bubble in the late 1990s. Therefore it is important to define your risk before entering a position.

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About the Author
M. Burkhardt is the CEO of option education firm RandomWalk Trading. Additional educational material is available at randomwalktrading.com.