Well as I said here I hope to offer more example option trades as a form of education. So let’s look at two. These trades both involve limited risk, yet I would still classify both of them as “high risk”. The reason for the high risk designation is simply that they are both designed to pull off that “amazing”, yet “fraught with peril” trick of “attempting to catch a falling safe”, i.e., picking a bottom.
This piece discusses a trade using options on ticker JNK which is an ETF that trades junk bonds. The companion piece that uses a different approach to play a similar sitution in SLV is here.
Ticker JNK
As you can see in Figure 1 below:
*Junk bonds have absolutely gotten killed of late. Junk bonds are more highly correlated to the S&P 500 than they are to treasury bonds but they are susceptible to changes in interest rates. When you combine a weak stock market with an uncertain to higher interest rate environment – well, it “ain’t pretty”, as you can see in Figure 1.
*There is a chance of a glimmer of a hope that JNK is about to form a double bottom at or around $33.22 a shares. Now would I bet my retirement account on that? Not a chance! Would I bet “a couple of bucks?” Maybe. And that is what the example trade below is designed to accomplish. In a nutshell, as long as the recent low holds, the trade makes money. If it does not hold, it’s time to take a loss and head for the exits.
Figure 1 – JNK with high implied volatility and a potential double bottom forming (Courtesy www.OptionsAnalysis.com)
Before showing you the specifics please note the most important thing to know about a trade like this: It could get blown out of the water in a heartbeat.
In other words, by the time you read this it could have already been stopped out. While the trade below is an “example” and not a “recommendation”, the key thing to remember for a trader considering this type of trade is that they MUST stand ready to act if things go the wrong way. If you are not – or are not sure of you are or are not – then you should avoid trades like the one below.
The JNK Bull Put Spread
As you can also see in Figure 1, the implied volatility for options on ticker JNK is presently at the high end of the historical range. This tells us that there is a lot of time premium built in to the prices for JNK options and suggests that “selling premium” may be the best approach for trading JNK options.
The example trade involves selling the March JNK 33 strike price put option and buying the March JNK 30 strike price put option as displayed in Figure 2.
Figure 2 – JNK Bull Put Spread Risk Curves (Courtesy www.OptionsAnalysis.com)
The key things to note:
*The trade involves trading a 10-lot using a limit order to enter the spread at a credit of $0.57 (selling ten 33 puts at $0.72 and buying ten 30 puts at $0.15).
*The maximum profit potential is $570 and will be achieved if JNK closes above 33 at March option expiration (although the goal is to be out before then…read on)
*The maximum risk is $2,340 which would occur if JNK was at or below $30 at March option expiration (under no circumstances would we hold his trade and allow that to happen.
Stop-Losses
A trade may consider one of two (or possibly both) approaches to cutting a loss on this trade should the recent – and admittedly, extremely tenuous – low of $33.22 in JNK fail to hold.
Method #1:
The first would be to exit this option trade if JNK drops below $33.22. For example, if we exited this trade with JNK at $32.90 a share this trade could lose somewhere between $250 and $330 depending on how quickly it is hit.
So this approach essentially approach bets heavily on the recent low of $33.22 holding with an approximate risk of -$330 and a maximum profit potential of $570.
Method #2:
A closer look at the risk curves drawn in Figure 1 (each colored line on the right hand side represents the expected profit or loss based on the price of JNK as of a particular date) reveals that the actual “breakeven (at expiration) price for this trade is $32.43. In other words, there is in essence 3.22% of “downside protection” (the difference between the current price of $33.51 and the breakeven price of $32.43).
So a trader could alternatively decide to set a stop-loss just under $32.43 instead of at the higher level of $32.90. If JNK fell quickly to this lower level then this trade would experience a loss of roughly $575.
The tradeoff between Method #1 and Method #2 is that Method #2 has:
*A higher potential dollar risk, but also
*A higher probability of NOT getting stopped out
Summary
This example JNK trade qualifies as rank speculation as trying to “pick a bottom” is routinely “fraught with peril.” Still, it offers a reasonable tradeoff between potential reward and anticipated risk. In addition, it takes advantage of current high implied volatility levels for JNK options by “selling premium.”
One other thought would be to consider waiting for an actual double bottom to form before considering a position such as this.
Jay Kaeppel
