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/