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Phillip Wiegand, Optionetics.com
November 1, 2001

The market continues to send mixed signals to traders as they try to decipher what will happen in the near future.  A couple of times, the major indices have threatened to breakout to the upside, but the bears’ paws have squashed all attempts to rally.  However, the resiliency of this market to hold in there and not completely give it up yet has helped the bulls continue to press their bets.  Additionally, it is encouraging to see important support levels hold as the profit takers sweep their money off the table.  The uncertainty on the geo-political front is the wild card and we must take that into consideration when crafting our market assumptions.  Indeed, we are living and trading in a confusing environment.  

The important clues that I am focusing on are the technical patterns being formed in the Nasdaq 100 ($NDX), Nasdaq Composite ($COMPQ), and the Nasdaq 100 Trust (QQQ).  If you take a look at these price charts you will notice a triangle or consolidation pattern developing, which is indicative of a breakout.  However, this type of price pattern does not provide which direction the move will be.  Additionally, the Dow Jones ($INDU) and S&P 500 ($SPX) are continuing to hold a short-term uptrend pattern, which would be considered a positive for the overall market.  The consensus is that the Fed will continue to cut rates, which is bullish for stocks; but an unexpected change in monetary policy from the Fed and the markets could give up the ghost.  

My personal opinion is that we will continue to see some serious fireworks as we move forward.  A vast amount of uncertainty is still in the market and the direction we take will just depend on the news that is released and other developments around the world.  The move to the upside has the potential to be huge, given the low level of interest rates and the fact that there are trillions of dollars sitting on the sidelines.  If the move is to the downside, it could be devastating—just as we have seen in the past.  Therefore, it is important to use strategies that have limited risk in the event your original market assumptions are incorrect. Additionally, it is also important to hedge positions in order to make money when your original ideas are proven wrong.

How can we position ourselves to take advantage of a market that has the potential to move big, one way or the other?  There are a number of ways to structure effective positions in this environment, but taking a longer term perspective will help to eliminate much of the stress involved with shorter-term trading.  Options are such flexible instruments that you are only limited by your own imagination and creativity.  I would like to review the call ratio backspread strategy and how it can be used in this market.

The call ratio backspread is created with all calls, and is a combination trade that has two separate legs.  The trade is constructed by purchasing at-the-money [ATM] calls and selling in-the-money [ITM] calls, in a 2x1 or 3x2 ratio.  This means that if you were to purchase 2 calls, then 1 call would be sold; and if you were to buy 3 calls, then 2 calls would be sold.  When trading larger sizes, keep the ratio intact.  The underlying concept is that you are buying some calls and then selling some calls to help finance the purchase.  If the trade is constructed appropriately, then money can be made in either direction with unlimited profit potential to the upside

For example, let’s say that you think the market will go higher over the long haul, but you just have no idea what will happen in the near future.  A call ratio backspread using QQQ LEAPS options would allow you to participate in an upward move without incurring much risk.  The reward is unlimited to the upside and the reward to the downside is limited to the credit that was received when the trade was executed.  It is important to do these trades for a net credit.  

One thing to keep in mind is that you do not want to use options that have less than 90 days until expiration.  The reason for this is that the maximum risk is incurred if the underlying security does not move by expiration.  Therefore, you want to give yourself enough time for the security to move.  Lastly, you want to exit the trade at least 30 days prior to expiration, so that time decay does not hurt your profit/loss picture too badly.  Take a look at the risk profile of this type of trade and you will be able to see how powerful this strategy is.  

These are great trades to implement, and they allow you to participate in the market and yet not incur a large amount of risk.

Good luck!


Phillip Wiegand
Senior Writer & Trading Strategist
Optionetics.com ~ Your Options Education Site
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