Despite all global headwinds the U.S. equity markets have
shown great resilience. In fact the uptrend in equities has
proved that considering the present circumstances, equities are
still the best place to park money.
Nevertheless, with the Dow surpassing its all time high and
the S&P 500 hovering around its high water mark, the question
in everyone's mind is 'how much more can this continue without a
pullback?' (read
Three Most Popular ETFs of February
).
Some are starting to believe that a correction is imminent, or
at least overdue. But the markets have proved many pundits wrong
predicting a pullback in the recent past.
This makes a perfect case to be '
conservatively bullish
' on the market, especially in the near term. Given this outlook,
a
Bull Call Spread
options strategy on the
SPDR S&P 500 ETF (
SPY
)
might be worthwhile, especially given the recent pattern it has
exhibited.
As we can see from the chart above the ETF has resumed its
upward trajectory as indicated by the green parallel lines after
exhibiting some degree of distortion in the latter part of
February (red encircled portion). Furthermore it has a strong
momentum of 103.62, which has been relatively flat for quite some
time (read
Can the Dollar ETF (UUP) Finally Break Out?
).
These factors could play an important role in the ETF
sustaining these levels with a slight bullish bias past the March
expiry series.
Strategy
One possible way to play to play these trends are with
options. A potential lower risk technique could using a bull call
spread on SPY options.
An example of this technique is as follows:
Buy: At-the-Money SPY Call option with a strike price of 155,
March 2013 expiry currently trading at $0.71.
Sell: Out-of the-money SPY Call option with a strike price of
157, March 2013 expiry currently trading at $0.13.
SPY is currently trading at $154.82 (i.e. Spot Price).
Payoff
|
Action
|
Type of Option
|
Strike Price
|
Premium
|
Expiry
|
|
Buy
|
Call
|
155.00
|
$0.71
|
March 2013
|
|
Sell
|
Call
|
157.00
|
$0.13
|
March 2013
|
|
|
|
|
|
|
|
Maximum Loss (Risk)
|
|
|
|
$0.57
|
|
Break Even Point
|
|
|
|
$155.59
|
|
Reward
|
|
|
|
$1.41
|
|
Potential ROI
|
|
|
|
238%
|
|
Reward: Risk Ratio
|
|
|
|
2.38
|
Payoff Explained
This is a conservative strategy in which both profit and loss
is capped. The strategy starts with a first up initial investment
of $0.57 per lot which is the difference between the option
premium paid on buying, and the option premium received on
selling the option.
This also represents the maximum possible loss that an
investor can suffer, but only if both the options expire
worthless. A loss is realized if the underlying closes below the
breakeven point of $155.59 below expiry (read
Bet on the Euro with These 3 ETFs
).
However, the reward for the underlying strategy could be a
handsome $1.41 which can be achieved if the underlying (i.e. SPY)
increases to $155.59 (i.e. the break even point) or more from
current levels.
Therefore we are looking at less than a one percent increase
in the underlying for a 238% return on our investment. This
translates into a Reward: Risk ratio of 2.38 times (read
Two Amazing ETFs For S&P 500 Exposure
).
However, investors should note that the maximum possible gain
is limited to $1.42 per lot. Therefore even if the underlying
increased substantially more than the break even point, the
profit potential for this strategy remains the same.
Additionally, it is worth pointing out that the time until
expiration is pretty short and these contracts will need to move
favorably very soon. Thus, there is a definite possibility that
investors could see a loss with this technique.
But if you believe that the market can continue to surge
higher, and if you are seeking a lower risk short-term strategy,
a closer look at options could be the way to go for some
investors.
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The ideas expressed in this article are for illustrative
purposes only.
ISHARS-SP500 (IVV): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
VANGD-SP5 ETF (VOO): ETF Research Reports
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