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Yet Another Macro Event Driven Opportunity

|Includes: SPDR S&P 500 Trust ETF (SPY)

If one is willing to be moderately contrarian given the recent correction since late July knowing there is a major event looming this week - Obama's Jobs speech; one may want to consider an advanced options strategy: the bull spread.  This only if you think Obama will have something good to say and that it will be received extremely well by investors/traders.

Given VIX levels the cost of being outright long a call is a little costly and one may have to fork up a dire 4.1% ($4.80/$116.99) premium for an at-the-money call option on SPY.  This 4.1% is a certain loss if the ETF stays at or closes below 117 by the third Friday in October.  For risk tolerant investors such a trade may be appropriate if the sizing is appropriate in the context of an overall portfolio and you are willing to stomach the higher risk.  Remember sizing one's exposures appropriately is critical to successfully managing downside risk.  Your loss parameters in this case is absolute in that you cannot lose more than the premium paid for an option.

My preference given the uncertainty of the macro reaction and more so the cost to buy options given high levels of Volatility (read VIX) is to contemplate a bull spread given this scenario.  Recall I am "cheap" as mentioned in my "Debt Ceiling Volatility Offers Binomial Outcome" blog posting written back in July 12, 2011 suggesting a Reverse Iron Condor.

The diagram below illustrates the payoff diagram for a bull spread which can be created two ways using either calls or puts.  If employing calls you would buy a lower strike option while simultaneously sell a higher strike call option.  If employing puts you would be long the higher strike contract and short the lower strike contract.
Graph showing the expected profit or loss for the bull call spread option strategy in relation to the market price of the underlying security on option expiration date.

For illustration purposes only

Another good source for options related education can be found on the CBOE's website

Now you reduce your overall cost to profit if the SPY goes higher.  I would look at the $120/$121 pair using out-of-the-money call options.  This would net a maximum potential profit of $1 ($121 - $120) minus the net cost of $0.52 ($3.20 - $2.68) for the spread.  In essence this would offer a maximum return (excluding transaction costs) of 92% ($1.00/$0.52).  Not shabby for an event driven directional risk controlled trade.  You can see where the sizing comes into play so as not to lose your shirt in case the view does not turn out to pass the way one expects.  $52 for one bull spread exposure may not sound like much a loss but to make it worthwhile you may have to allocate more than $52.  Size based on either one f the following:

1.  Maximum dollar loss tolerance.  In other words how much of an aggregate dollar loss are you willing to stomach in order to pursue the potential gain of 92% on the amount invested?

2.  Maximum negative return contribution to portfolio.  In other words if you had 99% in cash and allocated the remaining 1% to the bull spread strategy you know your maximum loss would be 1%.

Now if you feel as though the market will have a big move either way, up or down, then other strategies including a Reverse Iron Condor, Strangles or Straddles could be appropriate given that view.

Let's see what happens after Thursday's speech.

This writing is meant to be educational in nature and should not be construed or interpreted as offering or soliciting investment advice.  This is for informational purposes only.  Investments can lose money and you should only invest in securities and strategies you understand or have consulted with a professional beforehand.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 48 hours.

Additional disclosure: I have no position in the Bull Spread strategy mentioned, but may initiate a position in such strategy over the next 48 hours.