By Josip Causic, Online Trading Academy Options Instructor

In this newsletter I will give an example of placing two different types of bearish strategies with two different expiration months on the same underlying. Once again I am advocating for being a Net Premium Seller.

This specific trade started as a volatility play. I noticed that on the ETF (Exchange Traded Fund) that tracks the Emerging Markets, the volatility for the back month, namely March of 2009, was much smaller than the volatility for the front month – January of this year. The trade JUMPED out at me, even without looking at the chart. A single glance at the EEM option chain showing the volatility percentages for January and March was enough to tell me that the EEM was worthwhile of my energy and time. However, I still had a bit more searching to do to determine if the EEM was the right product to trade.

Usually a trader needs to go through several steps when selecting the trade. First question is What to trade, the second is When to trade it, and the third one is By what strategy to trade it. 

For me, the question what to trade was reaffirmed after I had checked the liquidity of the EEM on the Yahoo finance page. (Here is the link, so in the future every one of our readers can easily check the daily liquidity for the most traded ETFs. The link is http://finance.yahoo.com/etf/browser/tv ) The Yahoo finance page on that day pointed out to me that the EEM was holding the bronze place for liquidity, right after the SPY and the QQQQ. To my surprise the IWM and the DIA were much lower than the EEM. This observation meant that I had two odds stacked up in my favor, the volatility as well as liquidity.
Nevertheless, I still had to do two more steps: check the charts and select an appropriate option strategy. By looking at the chart below, one could observe that I had marked with ovals the 27 zone as the level of resistance.

Figure 1

It did not take long for me to conclude, after looking at the chart, that my bias for the EEM was Bearish. I forecasted that the 27 area on the EEM is not going to be taken out easily, so I interpreted it as an area of resistance. In other words, the second question was answered – the EEM was at the resistance and it was a correct time to get into it. Question three was: By which strategy.  Now, there are a lot of strategies in my Bearish arsenal. To name a few possible Bearish strategies: (1) going short by simply selling the EEM, and later on buying it back for less than what I sold it for, (2) buying a directional put, (3) doing a type of Bearish vertical spread, either a Bear Call or Bear Put, (4) or doing a Horizontal Call Spread which would involve selling a call for the front month and buying a call for the back month. It was the very last strategy mentioned here that I started to entertain. I looked up the premiums on the March option chain for the 27 call and it was trading at the time for 2.45 or $245. I also checked how much I would get for the January 27 call if I sold it and the amount was 0.75 or $75. Therefore, the cost out of my pocket would be the difference between the two: 245 – 75 = 175. In my previous article on horizontal spreads I have discussed the intricacies of such a strategy. Please review it if you need a refresher on how it works. Anyhow, to place the horizontal spread on the EEM would cost me $175.

This next paragraph might throw some readers off because it involves thinking outside of the box. I did not like the fact that the money would be going out of my pocket, so I decided to finance this trade by selling a Bear Call spread on the EEM at the same time. Figure 2 below visually illustrates in a little bit more detail how both of those trades have the very same expectation. The reason for March being in bold is that after the January expiry, the March long position will be the only one that should have value left in it while all the others would expire worthless.

Certainly, a single quantity of a credit received from selling a Bear Call would not cover the cost of my horizontal spread, so I needed to go through a bit of calculation. A single Bear Call credit was $22 so I chose to sell eight of them to accumulate (22 times 8) $176 which would then pay for my horizontal spread. Figure 3 shows the exact the number of contracts that were involved in both transactions.

Although having a free trade sounds extremely attractive, I had to ensure that I was dead-on correct in my technical analysis. I could not possibly afford to have my Bear Call spread of eight contracts go against me just because I was using the credit from those eight contracts to finance my single Horizontal Call Spread trade. In the case of the trade going against me, there would be actually two trades going against me. Figure 4 shows the bottom line of how the whole trade had taken place. It shows how much I paid and received for each of my contracts.

Figure 4

Figure 5 is the screen shot taken on the third Friday of January after the market close. It shows that the maintenance of $800 dollars was held for entire duration of my trade.

Figure 5

This last figure shows the screen shot of my account in the late afternoon Saturday. It is only on Saturday that the expired worthless options are removed from the customer's account. Therefore be aware of this fact at any given time. All of my sold positions have expired worthless and I was left with $109 in profit as well as with the possibility to either close the March 27 call or with the possibility to sell another 27 call for February. Which one I chose is irrelevant for the big picture of this discussion.

Figure 6

In conclusion, I have used an example of creative option financing on the EEM to point out that it is possible to combine different option strategies at any given time (Horizontal Spread and Bear Call). Such creativity could be done at any time by anyone who understands the intricacies of Advanced Options. Personally, I love trading options because it allows me to express my creativity of thinking outside of the box. Yet the key thing is to know the option strategies inside out just as a painter knows his or her colors. Combining the options is like mixing the paints (yellow and blue) to get the desired (green) color. Know your paints; know your option strategies inside out. Good trading.

- Josip Causic

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

Reprints allowed for private reading only, for all else, please obtain permission.