By Andrew Giovinazzi
If there was any doubt about how the current budget negotiations are hampering the markets, one needs to look at the market activity yesterday just after Harry Reid made some comments.
One of my truisms about the equity market is that it hates uncertainty. A market will start to rally out of a bear spiral once it understands things can't really get worse even though things are pretty bad.
Use the rally in early 2009 as a case in point. Things were bad, but TARP and the non collapse of the financial system signaled the bottom. Usually equity prices reflect the concerns in lower prices so there is plenty of room to run. Currently, the worst thing that could happen is no deal and the typical kick-the-can approach that will leave the market and business investment limping along for 2013.
The fiscal cliff combination of spending cuts and taxes, which basically roll back the fiscal stimulus of 2009, are a solution just not the best one. Readers of my posts may have noticed most of the trades for MarketWatch have kept that in mind.
Investment setups keep this economic backdrop in mind. Using options to create investments offer some flexibility in this area. The trade that comes to mind is a risk reversal in a stock that is already creaking along close to its absolute lows and showing small signs of life.
A risk reversal position buys an out of the money (OTM) call and sells an OTM put with the goal of taking in a credit or at the minimum a very small debit. Since the put is short the underlying security really has to be really at some bottom. Controlling risk is possible by selling a put spread instead of a naked put. Employ this setup in stocks that have already lost most of their market value, trading at very low volatility or have considerable assets or cash. The idea is the investor has to be thrilled to be assigned the short put should it come to pass and is the key to controlling the risk in this trade. The upside gain on a runner could be quite nice.
I am a regular guest on The Options Insider's Radio Network Options Block program and one of the running jokes was my thesis in the spring with Zynga Inc. and Facebook Inc.
I thought Facebook would create a halo affect around other social media stocks, including Zynga. I was right about the halo except that Facebook pulled everything, including Zynga, into the basement. I was out of Zynga at around $6. Now we find ourselves at around $2.35 for Zynga. There is executive turnover and some turmoil at the company, but for all that, Zynga has had a hard time going lower and especially below the $2 handle.
This week I saw a giant risk reversal go up in the Zynga January 2014 cycle using the 2.5 calls and the 2 puts. Once a stock is on my radar screen it never really leaves but just sits there until a decent opportunity arises.
I like the idea of the ZNGA 2/3 (buying the ZNGA March 3 call and selling the ZNGA March 2 put) risk reversal in the March cycle. Right now it sets up for .04 to .06 and the trade means the effective entry price for ZNGA using the risk reversal set up would be $2.04 to $2.06 depending on the fill. That should provide enough room if the name does trade lower through between now and expiration. Also if you follow volatility notice there is considerable upside skew in the ZNGA options, which to me, means lots of buyers. The risk reversal should buy some time at very low cost. The idea would be to roll if ZNGA hits $3 and use the proceeds to roll to a higher risk reversal or straight in the money call six months or so out.
Disclosure: The author is bidding for a position in Zynga.