Using options to juice returns and limit risk.

Editors note: The option trading strategy presented today is designed to maximize returns in the event that the expected 5-15% correction does occur. This strategy does include the naked sale of call options which may or may not be available to all investors. Different brokerage firms have different rules and requirements to execute this type of option transaction. Option trading involves risk of loss and this trade scenario may or may not be suitable for your investment objectives.] With markets just off new recovery highs, we may want to begin thinking about a correction as predicted by the Stock Trader’s Almanac. There are so many ways to skin a cat when it comes to options strategies that it becomes overwhelming at times to choose the method which may work best during certain market conditions. Today we will look at several ways to profit from a market correction with a small amount of risk capital. The beauty of using options is that we do not have to feel that we need to call a top. We can enter the market in a general range and still withstand being “incorrect,” even making money if market moves in an unexpected direction. Simply Short The first and perhaps most obvious way to take advantage of a correction would simply be to short the instrument of our choice. For now we will use the exchange-traded fund SPDR S&P 500 (SPY) as an example. So, we would simply go short the SPY at roughly today’s price of $138.25. But what if, while we are waiting for a correction, the market goes up? The easiest thing to do to provide some protection for our theoretical short position would be to buy a call option in the front month which would be least expensive. We can also buy a call in a month further out in time and then just sit and wait. The disadvantages of this method include: a) If the market does go up, the call option purchased for protection will not move at the same rate as the underlying instrument, depending on which strike price is chosen, and in which month it expires in. b) If the market does do what we expect it to do, we have just “wasted” money on purchasing a call. Also, in order to enjoy continued protection we would have to buy another call at a lower strike price in a different expiration month thereby increasing our costs. c) We would have a need to micromanage this position on a daily basis which may be inconvenient for some of us. d) We would need enough capital to purchase SPY outright, which would significantly reduce leverage and limit gains in the event the market does decline as expected. Another option (so to speak) to take advantage of a significant move in the market, would be to buy a handful of puts and calls way out of the money and “hope” for the best. The drawback here is that we are not in the business of hoping or getting lucky – and you run the risk of losing money on both the puts and the calls. But, if we do get a significant move, the delta on one side would accelerate while your risk on the other side is defined and limited. So, that leaves us with the choice of simply buying a put close to the money. An SPY put close to the money will cost somewhere around $1000 in the month of December. I am choosing a December option in this case to give us enough time to allow the downward move to complete or be significant. Of course, if we realize the move sooner, we would gain more with an option that is further out in time because we would also be holding onto time value (theta) that can be quite significant. Disadvantages of this method would include: a) Risking that the SPY only moves down 10 points by December (an approx. 7% move) leaving us in a situation where we, at best, simply break even. b) Risking the loss of the entire $1000 if market ends up closing at our strike price or higher at expiration in December. A Win/Win Scenario We are left here with a dilemma as to what to do that would result in a win/win situation. We want to take advantage of a SPY correction, but we don't necessarily want to “put” up that much risk capital. An excellent way to execute this trade is to buy a put option in December that is slightly out of the money, leaving us plenty of time for a downside correction. We can then sell an in the money call option in December creating a synthetic short position which, assuming we are correct in our assessment of the market, will pay for the cost of the put. [Editor’s note: This is a synthetic short position because we expect and desire the in the money December call that was sold to decline in value and expire worthless.] Now we are in a situation where we are short two contracts. This seems like a risky proposition. To remedy this, we then buy two out of the money call options, one in the front month and one in December. The December long call option would act as one leg of a credit spread against the short December call option (leaving us with a defined risk situation if market were to shoot up) and the other call option would act at as protection against the outright put purchase. An option credit spread is simply the purchase of one option and the sale of another in the same contract month in such a way that the writer of the spread receives a credit. The advantages of this approach are: a) A “free” long put option (so to speak), leaving an open ended possibility of capturing a gain when the SPY does decline. b) Protection against a sharp, unexpected move, to the upside in the near future. Remember as market moves we can “roll” these protective calls at different strike prices into the future. c) Limited risk. As you will see in the numbers delineated below. To cover most of the cost of the December 137 put we will do a credit spread that also expires in December by purchasing a 142 call for $623 and selling a December 127 call for $1770. The reason for going in the money in this case is, although we believe the market will go down, if it does go up the spread will widen less than an out of the money credit spread and therefore reduce exposure to risk. The value of this spread (difference between two strikes) is $1500 if the spread were to max out against us. In order for this to occur, SPY would need to be trading above $142 at December option expiration. We took in $1147 which is difference in premium received on the sale of the in the money December 127 call and the purchase of the December 142 out of money call ($1770- $623). At this point we have paid for the December 137 put and are left with a net credit of $207, but we remain exposed to a large unexpected move to the upside. In order to alleviate this, we could simply buy a slightly out of the money June 142 call for $198. Or we could will sell an out of the money December 147 call for $395 and purchase the June 142 call. The net result of this leaves a credit of $404 in our account. This money can be used to roll forward the June call as needed to maintain our protection in the event that the SPY does not correct before June option expiration. We would gain most if market corrects 10% or more. If the market goes sideways and SPY closes somewhere around $138 in December there will be a defined loss. But, we do not plan to hold these positions through December option expiration and adjustments can be made along the way in accordance with changes in market conditions. Disclaimer Note: At press time,  Rose Conforti did not hold any positions in SPY or its options, but may buy and sell at anytime. Rose Conforti, Chief Strategist at Lotus Capital Group, has been trading stocks, stock options, stock index options, foreign currency exchange contracts and options on futures since 2007. She has a degree in Economics from the College of Mount Saint Vincent and is currently writing a book on options trading.