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Trade of the Day 1.24.13

K. Tanner

Market: e-Mini S&P 500 Futures, $ES_f, ES

Buy or Sell?: Use an option spread to "go short" with room for error

Range: We see the possibility of a test of psychological resistance near
1500, and possibly technical resistance near 1510 but the market is near
potential reversal areas

The red lines represent the strike prices of short options within the
spread; the green line represents long options. Maximum risk occurs above
the top red line, maximum gain occurs below the bottom red line.

How to "Get Short" with Some Room for Error

The bears are really starting to feel the pain. Many that we talk to have
been holding short futures for several days, or weeks, but have been unable
to draw a stopping point. After all, the rally has been in small increments
and this often encourages traders to become complacent.

The chart suggests a test of 1501ish in the ES is possible, but we all know
a market taking the stairs up often takes the elevator down. If it turns, it
can easily leave a lot of "would-be" bears on the sidelines. If you want to
gain exposure to the downside of this market without immediate risk, you can
try a bear put spread with a naked leg.

Specifically, you can buy a March 1485 put option, sell a March 1510 call
and then sell a 1430 put. This combination can be done for "even money"
before commissions and fees. In other words, for little to no out of pocket
expense, you can go short the ES from 1485, with a max profit at expiration
occurring at 1430 or below. If the market is below 1430 at expiration, the
trade is profitable by nearly $2,750 but the trade doesn't benefit from
additional weakness below 1430. Assuming a "free" entry, the risk on this
trade is commission paid as long as the market stays below 1510. If the
market is above 1510 at expiration (at which point it is similar to being
short a futures contract) the trade faces unlimited risk.

The premise of this trade is to gain downside exposure without the immediate
risk of shorting a futures contract, nor the out of pocket expense of buying
a put option outright.

Although it is cheap, or free, in regard to price...there is risk and,
therefore, margin required. We anticipate the margin on this trade to be
about $1,800.

Keep in mind this strategy is a little more aggressive than the typical
short option trades we typically recommend simply because the premium
collected is consumed by the purchase of a put spread.