CASE STUDY — ANR Jan 4 – 8 Bullish Risk Reversal — *closed*

| August 1, 2012 | 0 Comments More

Alpha Natural Resources (ANR) is off morning lows of $6.48 and now up a penny to $7.01. The Jan 4 – 8 bullish risk-reversal on the coal producer is seeing interest again today. Nearly 25,000 traded Friday (see 7/27 color). Today, another 7,500 were bought to open on ISE, according to ISEE data, and 6,000 traded for 79 cents on ARCA. More than 15,000 traded in both contracts and the positioning comes as shares try to recoup some of the steep losses suffered during the past 18 months. ANR is down nearly 90 percent from the highs seen in January 2011. Short interest as of 7/13 was 22.7 million shares and 11.8 percent of float. Earnings come into play the morning of August 8. The bullish combos Friday and Monday seem to express confidence in the stock heading into earnings and beyond. Let’s consider it as a Case Study and replace (Close out) the Case Study on BTU, which is within the same sector.

A bullish risk-reversal is a straightforward combination play in which the investor is selling downside puts to buy upside calls. The risk-reward is similar to a synthetic stock position (buying calls and selling puts with the same strike and same expiration month), but in a typical risky, the investor is selling downside puts to buy upside calls. Both contracts are out-of-the-money and the trade can be initiated for a debit, credit, or at even money. The strategy can take advantage of implied volatility skew and the fact that out-of-the-money puts often have higher implied volatility compared to out-of-the-money calls.

Like when selling naked puts, the investor stands ready to be assigned on the puts and buy the underlying at the strike price of the put. That is, if shares fall below the strike of the put, assignment becomes a factor at or near the expiration. A downside move in the underlying is the biggest risk to the bullish risk-reversal. The breakeven (at expiration) when the combo is initiated for a debit, is equal to the call strike plus the debit. The debit is at risk if shares hold between the two trikes. When sold for a credit, the breakeven of the risk-reversal is the put strike minus the credit and the credit is kept if shares hold between the two strikes and both contracts expire worthless. The best profits from a bullish risk-reversal, whether for a credit or debit, occur if shares rally and the calls increase in value – with theoretically no limit for potential gains.

In this case, shares are trading for7.01 and ANR Jan 4 – 8 Bullish Risk Reversal traded for 0.79. The max risk to the trade is the debit paid plus the put strike, if shares fall to zero, or 5.13 and the debit is also at risk if shares hold above the put strike. The breakeven is equal to the call strike plus the net debit, or 8.79 and 25.4 percent from current levels. The max profits happen if shares rally beyond the breakeven. Of course, the position can also be closed out for a profit or loss at any time prior to the expiration. The OptionsXpress payoff chart shows the risk-rewards and probabilities of success graphically.

Case Study-ANR Jan 4 – 8
Bullish Risk Reversal
Bias = Bullish
Risk = Debit Plus Put Strike.
Reward = Theoretically Unlimited to Upside
Breakeven(debit)= call strike+debit =8.79

Download PDF—> ANRBullishRiskReversal

Closed — 11/01/12

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Category: All Stocks, Basic Resources, Small Cap Stocks, Trading Education

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About the Author (Author Profile)

Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.