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Weekend Review by Russell Rhoads, CFA

by rrhoads on 02-25-2012 05:38 PM

Barron’s –

 

Steven Sears writes about risk reversals in this weekend’s Striking Price column.  A risk reversal may encompass a variety of strategies, but the method discussed in his column involves selling an out of the money put and using the proceeds to purchase calls.  The result is the obligation to buy an underlying security at a lower price and the right to buy at a higher price.  With low volatility in the market a few suggestions are made to implement this strategy on market related exchange traded funds such as the SPDR S&P 500 ETF Trust (SPY – 136.93), iShares Russell 2000 (IWM – 82.64), and iShares MSCI Emerging Market ETF (EEM – 44.19).

 

Options Action –

 

The guys started out talking about strength in the overall stock market, but noting some caution based on oil and gold climbing to higher levels.  They cited geopolitical risk as the catalyst behind higher oil and risk of inflation as the reason behind higher gold prices.  Both of these factors could weigh on the stock market if they were to come to fruition.

 

The first trading recommendation is on Caterpillar (CAT – 116.00) and is looking out to April expiration.  CAT tends to trade in line with the price of oil and if the commodity backs off in price so may shares of CAT.  Looking out to April buying a CAT Apr 110 Put for 2.40 and selling a CAT Apr 105 Put for 1.40 is recommended.  This put spread would result in a profit of $4.00 if CAT is at 105 or lower.  Above 110 at April expiration the spread is a loser of $1.00 which is also the cost of initiating the spread.

 

The other recommendation is to buy a call option on Exxon Mobil (XOM – 87.34 ) as the stock is fairly inexpensive and due to the low volatility in the overall market options are cheap as well.  Like the CAT trade this trade focuses on April expiration and is a purchase of the XOM Apr 90 Call at 0.80.  Below 90.00 at April expiration this trade is out the 0.80 premium paid and as long as the stock is over 90.80 at expiration a profit will be the result.

 

 

One final note – if you haven’t heard Warren Buffet has released his annual letter to investors.  A full read can be found at http://www.berkshirehathaway.com/

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About the Author
  • Mr. Bittman is the author of two books, Options for the Stock Investor, (McGraw-Hill, 1996), and Trading Index Options (McGraw-Hill, 1998). He teaches courses for public and institutional investors, and he has presented several custom courses throughout the U.S., Europe, South America and Southeast Asia. In 1980 Mr. Bittman began his trading career as an equity options market maker at the Chicago Board Options Exchange. From 1983 to 1993, he was a Commodity Options Member of the Chicago Board of Trade where he traded options on financial futures and agricultural futures. Mr. Bittman received a BA, magna cum laude, from Amherst College in 1972 and an MBA from Harvard University in 1974. In addition to his responsibilities at The Options Institute, Mr. Bittman is also a member of the faculty of The Illinois Institute of Technology, where he teaches in the masters level Financial Markets and Trading Program.
  • Mr. Kearney began his long association with the CBOE when he became an independent Market Maker in early 1981. Mr. Kearney traded options full time on the trading floor until 1992 and periodically thereafter until 1996. In early 1992 he became a founding partner and Registered Options Principal of a brokerage firm based in Chicago, a member firm of the CBOE. Mr. Kearney’s responsibilities included development and implementation of hedging and trading strategies using listed options for their institutional clients as well as their retail investors. Mr. Kearney is the co-author of Understanding LEAPS®, published by McGraw-Hill, September 2002. He has been a regular contributor to many news services including Reuters, Derivatives Week, BARRON’S, CNBC, Bloomberg, Group W, The CBS Radio Network, FORTUNE, Ticker Magazine, Stock Futures and Options, BBC TV and Radio, NPR, and others. Mr. Kearney served on various committees at the CBOE, including the Arbitration Committee from 1984 to 1996. Prior to joining the CBOE Mr. Kearney was a marketing director for NCR Corporation. Mr. Kearney is a graduate of St. Mary’s University (MN), BS, 1971, and pursued his MBA at Lake Forest Graduate School of Management. In 2006 he completed a 3-year SII/SIA program at the Wharton School of the University of Pennsylvania.
  • Peter B. Lusk is an instructor at the Options Institute, the educational arm of the Chicago Board Options Exchange. He teaches option courses for public and institutional traders and has contributed educational type articles to various financial publications. Peter has spoken to thousands of investors across North America the past few years including over 200 webinars for the CBOE and member firms on trading options. He can also be seen each week on CBOE-TV with his show, Strategy of the Week. In addition to his responsibilities at the Options Institute, Peter serves as an Instructor for the Options Industry Council – an organization representing the options industry in the U.S. Prior to working at the Options Institute, Peter was a highly successful market maker for many years on the floor of the CBOE trading equity options. He was also involved in options training for new market makers at Lakota Trading in Chicago. As a professional trader, Peter enjoys sharing his knowledge of proven option strategies and risk management at the Options Institute.
  • Russell Rhoads, CFA, is an instructor with the Options Institute at the Chicago Board Options Exchange. He joined the Institute in 2008 after a career as an investment analyst and trader with a variety of firms including Highland Capital Management, Caldwell & Orkin Investment Counsel, TradeLink Securities and Millenium Management. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies. Since joining the Options Institute he authored Option Spread Trading: A Comprehensive Guide to Strategies and Tactics which was released in January 2011 and recently finished work on Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Traded Notes which was published in August 2011. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois – Chicago and acts as an instructor for the Options Industry Council. He is a double graduate of the University of Memphis with a BBA ('92) and an MS ('94) in Finance and also received a Master's Certificate in Financial Engineering from the Illinois Institute of Technology in 2003.
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