Tuesday, May 11, 2010

Risk Rocket

In last month's Sling Shot post I reviewed a bullish combo strategy involving the simultaneous purchase of stock and call options. The power of the play lies in its ability to be adjusted into various risk free spread positions. Given the multiple adjustments available I suggested using decision trees to better organize the varying choices at different forks in the road. Turns out the phrase "sling shot" has been used to describe another option strategy. I've never been one to quibble over names of strategies as I believe the key lies in understanding the structure of the play and how to manage it, not the name. However, for simplicity purposes it's obviously nice to have some type of name for each strategy. I mean, long stock long call combo doesn't exactly roll off the tongue, ya know? So, given its similarities to a risk reversal, going forward I'll refer to this particular play as a Risk Rocket.

With this week's historic turn of events and the potential trend reversal playing out in the overall market, let's explore a bearish risk rocket poised to exploit a continued downward move in the SPY. Suppose we shorted 100 shares of the SPY today around $116.50 and simultaneously purchased two June 111 puts for $1.95 apiece. Take a gander at the risk graph:

[Source: MachTrader]

The game plan is to buy to cover the stock within a few days, following a 1 ATR drop. The profit from the stock should pay for most of the cost of the long puts. Following this initial adjustment we may consider rolling the long puts to some type of spread in order to bring in additional credit. The premium received will further reduce the risk of the position and potentially put us into a minimum reward scenario. The following decision tree outlines potential adjustments for consideration:

Assuming this play pans out, I'll offer a follow up post exploring various adjustments.

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