From the December 2013 issue of Futures Magazine • Subscribe!

Using a risk reversal spread for protection in volatile markets

Questions: How can I protect myself when upcoming events could rock the markets?

Answer: Use a risk reversal -- Long put spread combined with short call spread.

Now that the markets are at all-time highs, most people can’t help but think of the idiom erroneously attributed to Isaac Newton: “What goes up must come down.” 

Regardless of your opinion as to where the final destination of this market move will conclude before reversing, you cannot help but worry about the three blind mice coming our way in 2014. 

Trifecta events

1. Fed stimulus taper

Historically, the market crashes within six months of a dramatic negative Fed policy change. We have had many false tapering alarms, but the markets are almost certain March will be the taper. 

2. Government shutdown part II 

Though known as a farce by the majority of the world, the fear of the unknown is a negative for the market. The last shutdown saw the Dow fall from 15,700 to 14,800. 

3. New Fed chairman

Alan Greenspan took office on Aug. 11, 1987, and Black Monday occurred on Oct. 19.  Ben Bernanke took office on Feb. 1, 2006, and two years later we had the world banking collapse. What’s in store for Janet Yellen’s baptism? 

Here is a riddle: Will the laws of physics dictate that this market in bullish motion remains in motion, or will an inevitable retrenchment occur?  

Problem

Most option traders know the benefits of a vertical spread over that of a naked option. If bearish in opinion, many option traders will contemplate the purchase of a long put spread or the sale of a call spread. 

Long Put Spread

Simply purchasing a put spread to take advantage of a possible decline can be costly if the selling doesn’t occur or is not strong enough. The market could decline and the spread still would expire worthless.  

Short Call Spread

Selling a call spread can work out nicely, but selling an out-of-the-money $5 or $10 wide index call spread at $1 or $2 is not the bang for the buck option traders look for in large moves. 

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