FAS and FAZ Leveraged ETF Call Spreads: Playing the Reverse Side of the Trade

 |  Includes: FAS, FAZ
by: David Oldenburg

Read part 1: FAS and Leveraged ETF Call Spreads

In my first article on this topic, I spoke about using a Bull Leap Call Spread to greatly reduce your capital invested when purchasing a leveraged ETF (like FAS or FAZ) and hoping for a directional move. I promised in the first article to follow up with a part 2, covering when to get out of this trade and how to play the inverse or reverse side of the trade.

There are a lot of people who are telling me they believe the market will correct and that FAZ will jump considerably. I outline below a trade that risks about a $1.31 and can gain 335% if FAZ does break out. I got a lot of feedback on my website and email on the first article telling me that there is a high number of FAS and FAZ traders each day.

First, let's talk about FAS and Part 1 of this article (see link at the beginning of this piece). If we go back just over 45 days to November 30th, we see FAS closing the day at $21.37, according to TOS. On November 30th, we could have put on a Bull Leap Call Spread, by buying the JAN 2012 $22 Call Option for $5.25 ($525 per contract) and selling the JAN 2012 $35 Call Option for $2.55 ($255 per contract). We would have paid $525 and received back $255. Our total cost to put on this trade would be $270 + the cost of any commissions. Our maximum gain or profit potential would be $10 (the difference between the strike prices) x 100 shares = $1,000 minus the $270 cost to put on the trade = $730. If we invest $270 and can profit $730, we have a max profit of about $170% if FAS is trading at $35 or higher on JAN 2012 options expiration date.

The most common question I get on options trades is when to get out of them and how long to wait. Let's examine where we would be if we had held this trade to today. Today FAS closed at $31.16. The JAN $25 Call Option that we bought for $5.25 can be sold today for $10. The JAN $35 Call option we sold for $2.55 can now be bought for $5.80. If we closed out the position, we could sell our $25 call for $1,000 ($10 x 100) and we could close out our $35 short call for $580 ($5.80 x 100). That makes our total gain $420 but we spent $270 to put on the trade. Our net gain is $150 or we made a 55% return in just over 45 days.

The most important point of this illustration is that even though we put on a trade with options that had a 12+ month expiration date, we had a significant profit after just 45 days. I always believe in having an exit strategy before you enter a trade. While you still have a lot of time left in this trade (almost a full year), FAS is highly leveraged and does underperform over the long-term. When I do spreads like this one, I generally will exit the trade if I am up 50% or more, unless I believe there is a strong indication that the underlying will continue to rise. There are also some strategies you can do at this point to manage the trade and reduce the risk if you do want to hold it. I will cover those in a future article.

So, let's talk the inverse or reverse trade by playing FAZ. FAZ is supposed to be the short side of the FAS. In theory, if FAS is up 10%, FAZ would be down 10% and vice-versa. However, over a long period of time they both tend to underperform (please see my article Financial ETFs: Shorting FAS, FAZ at the Same Time for more on this).

If you believe that the market will drop and FAZ will rise, you can do the same Bull Call Leap Spread on FAZ that we have been discussing on FAS. I like this play better than shorting FAS. If I short FAS, I have unlimited risk to the upside and FAS is a 3x leveraged ETF. I will say again as I have in previous articles, it is a very bad idea to short a 3x leveraged ETF or any other stock if you do not have adequate protection. You can lose all of your investment very quickly in a breakout market.

FAZ today is at $8.32 and I can buy a JAN 2012 $8 Call Option for $2.31 and I can sell a JAN 2012 $15 Call Option for $1.00. My net cost is just $1.31 or $131 per contract. That is also my max loss if I am wrong and the market takes off to the upside. However, my max profit is the difference between the strike prices, minus my investment. The difference between the strike prices is $7 and my investment is $1,31, so I can make a max of $5.69 profit (or $569 per contract). My investment is $1.31 and my max gain is $5.69 or 335%.

There are a lot of people who would buy FAZ and hope it doubles in value from near $8 today to near $16 at some point in the future. However, they spend and risk a lot more money and end up with a 100% return if they are right. With the Bull Leap Call Spread we have just discussed on FAZ, they risk a fraction of the money and can earn a 335% return on their investment. Some people will say, why not do a Bull Call Leap Spread on both FAZ and FAS at the same time? Regardless of which one wins, it will be enough to cover the small loss on the other one, right?

It's not quite that simple. Remember that these are not credit spreads and they each cost money to put on the trade. In addition, they could both trade sideways and you could lose your max on each trade. I will outline the pros and cons of opposite spreads in a later article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.