Return Some Green Betting on the Greenback With This Bullish Option Strategy

Includes: SPY, TLT, UUP
by: Option Maestro

Someone once asked me "how have you made the most money playing in the stock market?" I had to think long and hard because in today's market there's no easy answer like the old days "buy and hold", today it's necessary to constantly research and change positions on the market, as the economic environment and other factors change.

After I put some thought into it, I was able to come up with one theme that equated to my most successful runs in the market, that is being a contrarian when it seems everyone shares the same idea (okay not everyone but the vast majority). First of all I'm a big believer of "the trend is your friend", but when things seem to be extremely overdone, I like jumping to the other side and sticking to my guns.

A good question would be when are things extremely overdone? It's just a feeling that comes naturally to most people. One example would have been when the market was melting down in late 2008 and it seemed every person on TV, each article online, and even your neighbor, who has no idea how to play the stock market, was calling for an even deeper correction. This would have been a great time to get long the market. Even though you wouldn't have caught the bottom in late 2008 (came in March of 2009), it was an excellent time to be buying stocks. Another recent event was when the Euro was hitting all time highs in the summer of 2008, and famous super models demanded pay in Euros, and rap stars were writing lyrics about the Euro, these were times I did happen to get long the dollar against the Euro for an excellent trade.

It seems to me the dollar has become everybody's favorite short trade once again, and it's no secret the dollar has been a favorite short by many large funds. In this article I will detail why I believe it is worth getting long the US Dollar, and how I am doing so.

Using the very popular PowerShares US Dollar Index Fund ETF (NYSEARCA:UUP), an ETF that is long the dollar against a basket of other currencies, we can see the performance of the US Dollar over the last 4 years (since fund inception February 2007).

(click chart to enlarge)

We can see the Dollar has been in a downtrend since inception with two major spikes in between. We can see the UUP is nearing multi year lows and significant support near 22 per share (blue straight line). The later spike may still be fresh in your memory, it was the Euro crisis when Greece was on the edge of default. The Euro dropped to a multi year low of 1.19 against the dollar, but when things settled down and things went "back to normal", the dollar started to weaken once again.

The dollar had a very strong day Friday as events in Egypt really starting heating up. We could have seen some of the short sellers covering positions ahead of the weekend, but the action in the dollar Friday clearly demonstrates that in times of global uncertainty, the US Dollar is still one of the most favorable currencies.

However, the events in Europe last spring, and the current events in Egypt demonstrating that in times of crisis the US Dollar is still favorable aren't the only reasons I'm getting long the US Dollar, even though I expect more global uncertainty in the future. I believe the dollar is due for a period of revaluation based on rising interest rates.

The million dollar question is, "when will the Fed start raising rates?", and that I cannot answer. However, I can answer that based on bond prices and yields recently, the fixed income market is factoring in a hike in rates sooner rather than later. Using another very popular ETF, the iShares Barclays 20+ Year Treasury Bond Fund (NYSEARCA:TLT), we can see that the price of the fund has pulled back nearly 15% from the August 2010 highs based on a higher interest rate. For those who may not know, bond prices increase to reflect lower yields, and bond prices decrease to reflect higher yields. Hold a pen in your hand, and call the left side bond price and right side bond yield. Push the left side down, and you'll see as bond prices decrease, bond rates increase. The longer term chart of the TLT shows monetary easing and decreasing interest rates which is why the fund has appreciated in value.

(click chart to enlarge)

In times of rising interest rates the dollar becomes stronger, and vice versa. Simply because of the notion that if the Fed is tightening, dollars are harder to come by, which is why lending becomes more expensive. It is also very important to note that the fed doesn't need to raise rates directly, interest rates can be "talked up", meaning, if the fed hints toward hiking rates the market will move ahead of the actual rate hike. If interest rates are even hiked up this could be a major positive for the US Dollar.

With that being said I will outline how I am playing the US Dollar. The volatility in the US Dollar is historically very low (although from recent action one may not believe that), meaning options on it are quite cheap. I would choose to trade options on the UUP because my risk is limited and it allows me to leverage my position. 1,000 shares of UUP would cost me $22,500 versus 10 June 21 (rights to 1,000 shares at 21 per share until June 17, 2011) in the money option contracts, tracking the UUP nearly penny for penny, that would cost me $1,600. Since options on the UUP are so cheap, I have no problem buying longer dated call options, giving myself plenty of time.

UUP Bullish Option Strategy:
I would open vertical call spreads by purchasing January 2012 23 strike call options and selling January 2012 26 strike call options against them. This strategy would cost me a net of $60 per spread, and if the dollar rallies significantly, I could bank some serious green (pun intended). This limits my risk to $60 per call spread and gives me just over 350 days to be long the dollar. Again, the maximum I can lose is 100% of my premium paid, which is $60 per call spread and would result if the UUP closed at or below 23 per share on January 2012 options expiration (January 20, 2012).

If, however, the UUP rallied and closed at or above 26 per share-- which is the maximum this strategy could return, on January 2012 options expiration-- this position would return $300 or 500%. The break even point for this strategy is if shares of UUP closed at exactly 23.60 per share on January 2012 options expiration. Every penny above 23.60 would result in a profit up to 26 per share.

The strategy outlined above presents a good entry point into the US Dollar as it limits the risk and gives one significant potential returns. The strategy can also be closed out at anytime before January 2012, so if the dollar rallies in mid 2011, it could present a good opportunity to get out of this strategy and roll to another strategy, taking some or all of the risk off the table (ie, rolling to March of 2012 24/27 call spreads).

Commissions were not taken into account for the calculations above. I am currently long these spreads, so I will do my best to update my readers on any changes I make on this position as needed via Seeking Alpha StockTalk or I'll comment in the comment section of this article.

The ideas outlined above are bullish strategies and should not be considered if you think the ETF will sell off in the near future. However, if you feel the stock could move higher in the near future, this strategy could yield a nice gain.

These are just examples and are not recommendations to buy or sell any security; if you're more bullish/bearish, you’ll want to adjust the strike price and expiration accordingly.

The reason option volumes have surged in the last five years is because they are a great way to leverage / hedge your portfolio, as well as create income off of your shares (see chart here). Keep in mind when using this strategy that it is essential that broker commissions are low enough to profit from the position.

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

Additional disclosure: I am Long January UUP 23/26 Call Spreads