A Reversal and a Tidy Return

By Larry Benedict, editor, Trading With Larry Benedict

As my subscribers and regular readers of this e-letter will know, I’m a massive fan of using options.

With options, I always know my maximum risk. And risk management is crucial to being a successful trader.

When I buy an option, the most I can lose is the premium I pay. That makes them a great tool for retail investors – the risk is clearly defined.

Options also allow you to leverage your returns. For just a small outlay – even as low as $200-$300 – I can control thousands of dollars’ worth of a stock.

And that’s just what we did earlier this month…

By capturing a down move on an ETF, we generated a 41.7% return in nine days – all from an outlay of just $240. And that tidy return came despite the trade initially not going our way.

Today, I’m going to run through that trade to show how things panned out…

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Topped Out and Reversed

The trade involved buying a put option on the iShares 20 Plus Year Treasury Bond ETF (TLT). You buy a put option if you think the underlying stock (or asset) is going to fall. And TLT is an exchange-traded fund (ETF) that holds high-grade Treasury Bonds.

After peaking on May 22, bond yields had steadily fallen, causing bond prices to rise. Bond prices move opposite to yields.

But that move topped out and reversed in late June, as you can see in the chart below…

iShares 20 Plus Year Treasury Bond ETF (TLT)

Source: e-Signal

(Click here to expand image)

TLT’s slide then developed further as yields steadily recovered…

As the chart shows, that down move coincided with the Relative Strength Index (RSI) – a momentum indicator – reversing and tracking lower.

And with the RSI breaking into the lower half of its range – a bearish signal – we opened a put option position on TLT in anticipation of that down move developing further. Option contracts are for 100 shares. We paid $2.40 for the option, or a $240 contract.

But as you can see, almost as soon as we entered the trade, it reversed. But again, that’s why I use options – my maximum risk was still just $240 irrespective of whatever TLT did.

However, TLT then resumed its down move as the RSI reversed lower (black arrow) from right around resistance (green line) – another bearish signal.

And with TLT approaching a key level around $83, and Producer Price Inflation (PPI) data coming in flat on Wednesday at 0.0% and well below forecasts (bond prices typically rise when inflation falls, which could have adversely affected our position), we decided to exit our position by selling our put option.

All up, we banked $3.40 (or $340 per contract) – a 41.7% profit in just nine days.

Outsized Gains

As always, I need to reiterate that options magnify both gains and losses. That’s because options have a finite life. The clock is always ticking.

If the move you planned for doesn’t pan out within your time frame, you can lose all the premium you paid for the option if you hold the option all the way through to expiration. Remember, though, that you can close the position out at any time before expiration.

But as this trade shows, by using options, we can generate some outsized gains in a short time. All the while, always knowing our maximum risk.

And if volatility picks up, as I’m expecting in the second half of this year, managing that risk will become even more important.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict