UPDATED: SDS TRADE FROM MONDAY–Turn Risk Reversal Into Call Spread, Lock in Gains and Reduce Risk Profile

by Dan March 2, 2011 9:50 am • Commentary

[private][private]On Monday morning when the market opened up I was slightly dismayed at the complacency we had been showing since bottoming Friday morning.

I suggested the following trade to make a near term leveraged bearish trade in the SDS (the double short S&P 500 ETF):

RATHER than adding to my equity position, I decided to look at Risk Reversals (selling a put to buy a higher strike call in the same expiration-in this case).

TRADE: BUY the Mar 21/22 RR and take in a .20 credit with stock at ~$21.05.
-Sell 1 Mar 21 Put for .50 and use the proceeds to
-Buy 1 Mar 22 Put for .30

Break-Even on Mar Expiration:
-Downside: 21 or below you are Put the stock but don’t lose money until 20.80 as you received a .20 credit.
-Neutral: btw 21 and 22 you take in the .20 credit.
-Upside: above 22 up 4.5% you have max profit potential with no cap.

***mark to market you will have gains or loses as the stock moves closer and or through the strike you are long or short.

TRADE MANAGEMENT: because I got the direction right almost immediately I want to take advantage in the almost 1.5% sell off in the S&P which equated to an approximate 3% gain in the SDS ($21.75 as of writing this) yesterday and lock in some gains and change the risk profile of the trade…..

SO now I want to cover that Mar 21 Put that i shorted at .50 and pay .30 (locking  in .20 profit) and then Stay long the Mar 22 call that i bought for .30…..But to further lock in gains i want to now SELL the Mar 24 Call at .20.

SO I have very effectively changed the risk reward if this trade, lets break it down and see how…….

– I went from having the risk of being naked short a near the money Put, but having unlimited upside to eliminating the risk of being Put the stock…..additionally without the unknown risk of this trade i have clearly defined what i can MAKE and LOSE.

NOW  I am LONG the Mar 22 / 24 Call Spread which is worth .40.…that’s all you can lose at this point….and  you can make up to 1.60 if SDS is 24 or above on Mar exp.

But I have effectively paid nothing for the Call Spread (actually locked in a profit),  HERE’S HOW:when i put the trade on I took in a .20 credit, now i just locked in a .20 gain on the sale of the mar 21 put that i just covered, and locked in a .20 gain on the Mar 22 call that i am long by selling the Mar 24 call at .20…..So basically I cant lose a dime.  At this point i can sit back and hope the market continues its slide without any risk to the trade…..[/private][/private]