How to Profit from the Next Big Short the Risk Twist Spread

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TheoTR D By Don Kaufman

How to Profit From The Next Big Short The Risk Twist Spread

By Don Kaufman

Edition V1

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Contents

How To Profit From The Next Big Short 6 Positioning Your Portfolio for a BIG Move! 7 Why We Don’t Want to Use the More Familiar Ratio Back Spread 8 Risk Twist Spreads – Let’s Get Our Spread On . . . 11

Step 1: When to Place Risk Twist Spreads 13

Step 2: Liquidity and Product Selection 14

Step 3: Expiration Selection 16

Step 4: Strike Price Selection 17

Step 5: Margin and Risk on Risk Twist Spreads 20

Step 6: Trade Allocation 22

Step 7: Executing the Risk Twist Spread 24

Risk Twist Spread Entry Checklist 26 Exit Criteria for Risk Twist Spreads 27 After Closing the Trade, Build a New Trade! 29 Risk Twist Spread Odds and Ends 30 Next Steps 32

How To Profit From The Next Big Short

The Risk Twist Spread

The markets have been on a steady rise since the 2008 debacle, and it doesn’t take a crystal ball to predict that a correction is coming. Many experts believe we’re about to embark on what could be one of the most pivotal periods in our market’s history.

A steep decline could mean devastation for many. But for those with the right knowledge and tools, it could be a huge profit opportunity.

This report will introduce you to a method you can use to position yourself for a massive SHORT opportunity we see coming in the S&P 500 – and in a broader sense, the world markets. Once you learn this method you can use it in any market that is signaling a major downturn is on its way.

I’m not talking about a “get short and pray the market moves down” approach. I’m talking about taking a risk-defined position that enables you to maximize the profit potential that comes with a significant move in the markets.

Before we go any further, let’s look at the kind of opportunity being set up in the markets right now. Have you looked at an S&P 500 chart lately?

Prices are at dizzying heights. They can’t keep going straight up. Clearly, something big has to happen. We don’t know when it will happen, but we can prepare ourselves now to meet it and profit from it when it does.

Positioning Your Portfolio for a BIG Move!

How do we position ourselves most effectively for the possibility of an extreme move without exposing ourselves to drastic risks?

That’s an important question. As we know, any kind of trading comes with risk. How we handle our risk is directly correlated to our success in the markets. If we take too little risk, any gains we might make won’t be large enough to warrant the effort of trading. But if we take too much risk, there’s a good chance we’ll panic and continuously close positions at the worst possible times. We’ll keep exiting the market before the break we’re looking for comes, and end up losing money.

What we want is a method of trading that allows us to limit the amount of money we risk while still giving us great profit potential. In addition, since we don’t know when the big move is coming, we want to be able to enter positions now that we can hold for an extended period, so we won’t miss the big move when it finally happens.

The method I’m about to introduce you to fulfills all these criteria. It’s the Risk Twist Spread.

The Risk Twist Spread is a ratio-type option spread that we will apply to index and equity products. This approach puts us in a position to achieve maximum reward for minimal upfront cost.

The Risk Twist Spread screams:

Limit your exposure and maximize your potential!

But if you’re not familiar with Risk Twist Spreads, you may need a little convincing. You may even be thinking, why not just use something you’re more familiar with, like the ratio back spread?

Okay, let’s look at the put ratio back spread, so I can show you why the Risk Twist Spread is far superior.

Why We Don’t Want to Use the More Familiar Ratio Back Spread

The put back spread is a bearish option-trading strategy that involves selling a number of put options and buying more put options of the same underlying stock and expiration date at a lower strike price.

This is an unlimited profit, limited risk option-trading strategy that is taken when the trader believes an underlying stock or index product will experience a significant downside move.

Let’s look at a trading example with a bearish put ratio back spread. The idea with this method is to SELL a near-money put option, and with the credit we earn by selling that put, we BUY 3 out- of-the-money puts.

This spread does have phenomenal downside potential. HOWEVER, the trade is put on for a hefty debit, and the trader is faced with additional risks and margin requirements. Sure, you can make a boatload of money if the market tanks, but paying $529 plus commissions per ratio back spread for a downside shot is brutal IF the markets do not tank.

As the graphic shows, there can be skew in PUT option prices because out-of-the-money puts trade with higher implied volatility than near-money put options. Skew develops as the demand for out-of-the-money puts for use as a hedge increases along with the possibility that the market will “crash.”

The problem with skew is that it can make buying out-of-the-money puts costly – so costly that it might not be worth buying the puts to protect oneself.

In our example ratio spread, we are SELLING 1 of the 211 puts with a 16.68% implied volatility and BUYING 3 of the 201 puts for a 19.64% implied volatility. BRUTAL! The skew is against us by approximately 3 full points. This may not sound like much, but it’s a MASSIVE deficit as we are selling 1 contract and buying 3 contracts.

When we use back ratio spreads the skew negatively impacts the ratio spread dramatically and creates a less than viable strategy over the duration

Therefore, we are forced to look for alternatives to the ratio spread that allow us to take advantage of downside opportunity with less negative effects from the implied volatility skew.

Enter the Risk Twist Spread!

Risk Twist Spreads – Let’s Get Our Spread On . . .

You are about to learn about a highly effective trading strategy that we have spent considerable time fine-tuning. We have developed a series of steps for setting up the trade along with criteria to follow to make sure the market meets the requirements for this approach. So please pay attention to the details of this trade, and FOLLOW THE STEPS to the letter.

Please note the following points about this method:

The techniques that follow are NOT well-known ideas or strategies. So study them carefully and don’t assume you already know what they’re about. The criteria we set forth are of the utmost importance; apply the necessary criteria at each of the steps in order to construct viable positions. The risk in each trade we design will be moderately defined. Be comfortable with the amount of capital you put at risk as you MUST be capable of sustaining your position through unpredictable events.

The Risk Twist Difference

The Risk Twist Spread is a variation on the theme of the ratio spread we just looked at. However, these are the primary differences:

The Risk Twist Spread is designed to limit upfront expenditures for the trade. The Risk Twist Spread has a vertical spread embedded within it in order to offset the evil implied volatility skew. The Risk Twist Spread has HUGE profit potential should the markets tank!

Characteristics of Risk Twist Spreads

Risk Twist Spreads offer special advantages. Here are some of them:

Increase in value when exposed to heavy volatility Increase in value when markets sell off Significant profit potential in a downside market move Loses minimal capital if markets rally Loses minimal capital if markets continue to drift Need ONLY be placed a few times per year Is the PERFECT spread to reduce risk of a stock portfolio Is an excellent tool for those seeking large returns on a big market event

Steps and Criteria for Entering Risk Twist Spreads

Step 1 When to Place Risk Twist Spreads

Your first step is to make a general assessment of the market and get a feeling for whether the time is right to put in this type of trade.

Criteria for Deciding Whether to Position Yourself With a Risk Twist Spread

Is it time to put in a Risk Twist Spread? It may be if your answers to the following questions are “yes”:

Have markets been overbought for years? Is the VIX below 16? Do you want to protect your portfolio from wild or unforeseen events?

Considerations When Buying Risk Twist Spreads

One of the most important issues with regard to entering into Risk Twist Spreads is that you do NOT attempt to time the onset of risk. This is because you will NOT see the RISK coming until it smacks you directly in the head. Markets can tank at any time and most of all when YOU least expect it! Do NOT wait until the markets are breaking down and then decide to buy a Risk Twist Spread. Get yourself positioned early so you’ll be ready when the downward move begins. Risk Twist Spreads are placed and remain relevant for several months. This allows you to trade calmly. We look to place Risk Twist Spreads in lower risk environments. One measure of “lower risk” could be the VIX under the 16 level. Risk Twist Spreads need only be placed 4 times per year within quarterly expiration cycles. Any time can be viable for placing a Risk Twist Spread. Nevertheless, lower volatility environments are favorable to obtain lower pricing on the spreads.

Step 2 Liquidity and Product Selection

When it comes to using the Risk Twist Spread, ample liquidity is crucial to success. The underlying market must have massive liquidity or you will not be able to get in and out of trades in a timely manner.

Liquidity, Liquidity, Liquidity!

Not enough liquidity is NOT good enough.

If you have any questions about whether a market has enough liquidity, then it’s NOT liquid enough. When it comes to liquidity, go big or go home. Non-liquid products are a NON-STARTER. If you trade NON-liquid products, you will LOSE over the long run!

Here Is What You Want to Look For

You want to see tight Bid/Ask spreads and high open interest. Be careful to check the availability of weekly options in the product you intend to trade. Check the Bid/Ask spreads in several expiration cycles. Bid/Ask spreads can vary widely depending on volatility and overall liquidity. Be aware that liquidity is variable, but generally you want to be the smallest fish in the largest pond in order to achieve viable trade execution and option pricing. Consider Penny Increment markets such as SPY, IWM and QQQ for your initial trades using the Risk Twist Spread. Risk Twist Spreads are exceedingly powerful strategies and ONLY highly experienced traders should use them with products like SPX, NDX, and RUT.

Look at Option Volume

Option volume is critical in receiving good pricing when entering and exiting trades, so . .

Check the option volume in front-month contracts. Consult the specs on a near-term MONTHLY option expiration contract and examine the current level of volume. Look to see if several options with at-the-money strikes (strikes that are near the underlying price) have volume in the hundreds.

Markets With Generally GREAT Liquidity

If you’re looking for markets with viable liquidity, start with these:

SPY FB IWM AAPL QQQ GOOGL NFLX AMZN

Another Great Source of Liquid Markets: Indices and ETFs (Initially)

It is strongly suggested that when you first build Risk Twist Spreads, you look towards index or index-related ETFs. Don’t overreach yourself. Equity products like GOOGL can be viable candidates, but the logic and criteria need to be second nature to you before diving into products like this. Being straightforward in trading works. Keep it simple – stick with ETFs for the time being, and steer clear of the gamut of equity risks.

Step 3 Expiration Selection

A critical decision in any option purchase concerns the expiration date of your option contract.

Select the Right Expiration Date

Here are some guidelines to follow to get the best expiration for this method of trading.

Look to place Risk Twist Spreads using options with a minimum of 90 days until expiration and a maximum 130 days until expiration. Options with 90-130 days before expiration provide us with the duration and volatility we need to be a viable candidate for a successful trade.

For example, either of the two highlighted options in the accompanying graphic would work.

Give Yourself Plenty of Time

Here are some brief notes on expiration selection:

Generally, when trading indices and index-related ETFs, expirations will always be available for December, March, June, and August. We want to give ourselves time, so, for example, in mid-November, we would be considering a March Risk Twist Spread.

Step 4 Strike Price Selection

The next critical decision for your option purchase is selecting the right strike price.

Guidelines for Strike Price Selection

The Risk Twist Spread requires you to trade options with 3 different strike prices, ALL in the same expiration cycle. We will ALWAYS trade puts if bearish and calls if bullish. We NEVER mix calls with puts in ANY Risk Twist Spread. We will ALWAYS use the ratio 1 : 3 : 1

For example: Sell 1 put Buy 3 puts Sell 1 put

The Risk Twist Template for Strike Selection

We suggest you start with SPY or other major ETF product! Trade put options with the following pattern of deltas:

SELL X1 -.18 to -.22 delta put

BUY X3 -.22 to -.27 delta put

SELL X1 -.35 to -.40 delta put

The following graphic shows an example of where these options might fall in an actual market.

Cheat Sheet for Risk Twist Spreads

If you intend to use SPY for your Risk Twist Spread, here is a cheat sheet you can follow:

Sell 1 contract of a .35 to .40 delta put in the selected expiration cycle. Buy 3 contracts $10 farther-out-of-the-money. Sell 1 contract $2 farther-out-of-the-money of the options bought.

For this trade, the trader is selling a $10 wide spread in addition to buying a $2 wide spread. The trade breaks down to the following component spreads:

Price Matters! Check Your Risk Twist Spread

When buying a Risk Twist Spread in an index-related ETF such as SPY, you will be paying around .80 ($80) to 1.60 ($160) DEBIT for the trade. If the trade costs more than -.80 to -1.60 (that is, you are paying more than $80-$160), you MUST check the strikes and the ratio for possible mistakes. The Risk Twist Spread should look and be priced as follows:

Step 5 Margin and Risk on Risk Twist Spreads

Knowing how to manage your account is an important aspect of successfully implementing a program of Risk Twist Spreads. One of the issues you should consider is the reduction in the buying power of your account for each unit of the Risk Twist Spread you put on.

Risk Twist Spreads can be placed in IRA or tax-deferred accounts as well as Reg-T Margin accounts. Although retirement accounts do not offer “margin” per se, it’s always important to determine the reduction in buying power as you add trades. You should also take this into consideration if you are trading through a regular brokerage account.

Reduction in Buying Power

The following “reduction in buying power” calculations are designed as a guideline only. Brokerage firms industry-wide have the right to request and hold higher levels of margin and buying power above and beyond Reg-T minimums.

Note: If any of the discussion below is unclear to you, it is suggested that you to review our foundations material: Options 101, 201, and 301.

To begin, let’s once again break apart the Risk Twist Spread into its individual spread components:

In our example, we are SELLING the 211 put and BUYING the 201 put for a 2.29 CREDIT

In addition, we are BUYING 2 contracts of the 201 put and SELLING 1 contract of the 199 put for a 3.31 DEBIT

Putting in this short spread brings a reduction in buying power to our account as follows. We’ll look first at the short ratio component of the trade:

Being short 211 and long 201 puts means we’re in a SHORT vertical spread with $10 of risk. The difference between the 211 put we SOLD and the 201 puts we BOUGHT creates $10 reduction in buying power minus the 2.29 credit received. Therefore, our reduction in buying power is the width of the spread or $10 minus the 2.29 credit OR… $10 - $2.29 = $7.71 reduction in buying power on the short spread.

Now we’ll calculate the reduction buying power on the long ratio component of the trade:

When BUYING a ratio, the buying power reduction is as simple as the DEBIT paid for the spread, or in this case $3.31 We are BUYING 2 contracts of the 201 puts and SELLING 1 contract of the 199 put for a 3.31 DEBIT

Now we’ll put it all together to determine the spread’s total reduction in buying power:

$10 - $2.29 = $7.71 reduction in buying power on the short spread. 3.31 DEBIT for the long ratio spread. Total reduction in buying power for the spread $7.71 + $3.31 = $11.02

Looking at Margin vs. Buying Power: The margin held would be the width of the spread, or $10. However, the total reduction in buying power is the debit we pay for the Risk Twist Spread in addition to the margin held.

Finally, let’s look at the maximum risk of the Risk Twist Spread. In our example, in a worst-case scenario, we have the potential to lose $1,102 maximum on 1 unit of the Risk Twist Spread. However, please note that we have NO intention of sustaining this maximum risk. We will use definitive exit criteria in order to circumnavigate potential risks and avoid maximum loss.

Step 6 Trade Allocation

Now that we’ve broken down the margin and reduction in buying power of a Risk Twist Spread, we can go on to look at how many “units” we intend to allocate to a trade.

As we saw earlier, the Risk Twist Spread involves a 1:3:1 ratio. As such, the 1:3:1 ratio is what we consider to be 1 UNIT of a trade. Now, it’s up to you to decide how many UNITS of the Risk Twist Spread you would like to put in. How many full positions do you want to hold?

The first step is to identify WHY you intend to use the Risk Twist Spread.Generally, traders open positions for these reasons:

1. Hedge – reduce risk for a portfolio or various other positions 2. Profit – looking for outright profitability in the event the markets tank!

Trade Allocation for the Risk Twist Spread: Hedge

When using the Risk Twist Spread as a hedge, first recognize this spread type does not “kick in” until the markets are truly in the proverbial tank. Also, be aware that a hedge is designed to offset SOME, but not ALL risk.

If the markets do tank, how much will the Risk Twist Spread expand in price?

You can estimate that for a 10% move DOWN in markets, 1 unit of the Risk Twist Spread expands to approximately $1000 (conservatively). So, for example, if you are looking to reduce a degree of risk on a 100k portfolio, 4 Units of Risk Twist Spread would expand approximately $4,000 in the event of a 10% market move down.

The Risk Twist Spread expands in price further with far more significant moves. A 20% decline in markets can see 1 Unit of the Risk Twist Spread expand to $3000 (conservatively).

Trade Allocation for the Risk Twist: Profit

If you are looking to outright profit from the markets tanking, well then, you have come to the right place.

The key factor in allocation of the Risk Twist Spread for profit is the margin constraints. Recall that the Risk Twist Spread ONLY grips hold and becomes profitable with a significant move down in the markets. As such, you may be required to allocate capital and margin every 3 months to hold your position in a trade with a large potential pay-off but with few occurrences where the market performs as you wish.

The number of positions you can hold depends on the size of your account:

Account Size # of Positions You Can Hold

2k – 10 k 1 unit max

10k – 50k 2 – 6 units max

50k – 250k 6 – 10 units max

250k and over Go for it!

Don’t overreach yourself. Remember, “Trade small and live to trade another day!”

Step 7 Executing the Risk Twist Spread

Here’s the order on a possible Risk Twist Spread:

SOLD -1 1/-3/1 CUSTOM SPY 100 16 DEC 16/16 DEC 16/16 DEC 16 214/204/202 PUT/PUT/PUT @-.91 LMT

It looks scary, right? It’s NOT!

The Risk Twist Spread can be placed as ONE custom spread on the thinkorswim platform, or as pieces on any option-enabled platform.

Executing the Risk Twist Spread on thinkorswim

Create a custom order type on the platform as follows: • Hold down the CONTROL key and LEFT CLICK on the BID of the options you want to sell. • Hold down the CONTROL key and LEFT CLICK on the ASK of the options you want to buy.

You could also copy and paste this order directly into thinkorswim.

Executing the Risk Twist Spread on ANY Trading Application

It is possible you may NOT be able to place a custom order type at your preferred brokerage firm. If that’s the case, you simply have to break the Risk Twist Spread apart and place the 2 component trades separately.

The following displays in what order and how to execute the different components of the Risk Twist Spread:

First, SELL the Vertical Spread:

Second, BUY the ratio spread:

Finally, put the two chunks together and you have yourself a Risk Twist Spread!:

Risk Twist Spread Entry Checklist

Here is a handy summary checklist of points to remember when setting up your entry into a Risk Twist Spread:

1. Placing a Risk Twist Spread: consider using it where there is lower volatility, for a hedge, or in anticipation of market risk. 2. Product Selection and Liquidity: Use ETFs, SPY for starters. 3. Expiration Selection: Buy a Risk Twist Spread with 90-130 days remaining before expiration. 4. Strike Price Selection: SELL X 1 -.18 to -.22 delta put BUY X 3 -.22 to -.27 delta put SELL X 1 -.35 to -.40 delta put 5. Margin and Risk: Calculate the reduction in buying power of your trading account to make sure you can stay in the trade as long as needed. 6. Trade Allocation: Are you entering the trade as a Hedge or for a Profit? 7. Execute the Risk Twist Spread!

Exit Criteria for Risk Twist Spreads

Even if you put in the best-planned trade, it will be for nothing if you don’t exit it correctly. Here’s what you need to know.

Pull the Trigger and CLOSE THE TRADE

Let this be your mantra: “I shall CLOSE the Risk Twist Spread 4 weeks prior to expiration, regardless of a win, lose, or draw.”

This is critical because if you do not close out your Risk Twist Spread well before expiration, you could be subjected to the dreaded “Valley of Death.” This can happen during the last 30 days of an option’s lifecycle when theta decay accelerates. If, during that time period, the middle strike price of the Risk Twist Spread is still out-of-the-money, the premium will enter a steep decline. Traders will suffer the maximum loss if they don’t pay attention to the trade and hold until expiration AND the price of the underlying contract is exactly on the center strike.

Exit Profitability With HUGE Market Moves

The Risk Twist Spread is a lower probability HIGH IMPACT trade. These setups don’t happen that often, but when they do, it takes a substantial move down in the markets for the Risk Twist Spread to expand profitably – which means major profits for those who have established their positions.

But that brings another problem. When markets sell off BIG and offer such tempting profits, many traders find it extremely difficult to decide WHEN to exit the Risk Twist Spread.

Imagine you’re in the trade and there’s a decent sell off in the markets amounting to a10% decline. Your profits are mounting. You feel the market will keep expanding. How do you know when to get out? You’re constantly second guessing yourself, wondering if the markets will sell off even farther. You’re afraid you could end up leaving money on the table.

The truth is, no one has any idea when the bottom will be reached. So the best way to approach the situation is set a specific DOLLAR return on the Risk Twist Spread ahead of time, and then EXIT THE TRADE when that return is reached.

Once you’ve established the specific dollar return you’re going for, you’ve made it easy on yourself. No decision is necessary. Just exit the trade when your predetermined profit is attained.

It sounds great, but you still may have difficulty doing this in the heat of battle. So prepare yourself for it ahead of time by running simulations, identifying specific dollar amounts, and then exiting your simulated trades when the specific dollar amounts are achieved.

The graphic shows a Risk Twist Profit Simulation.

In this example, relative to a 10% down move in the markets with a 10% expansion in volatility, we conservatively estimate the Risk Twist Spread to be worth approximately $1000. Of course, you and ONLY YOU can determine precisely what you feel a large move down in markets happens to be; it’s all relative based on the significance of the occurrence at the time of the sell off.

For our example, let’s say we selected an exact exit profit point. We will use our $1000 per 1 unit of the Risk Twist Spread as our estimate for the exit point.

While it’s true that markets will possibly sell off farther than 10%, it is also true that holding the Risk Twist Spread in the face of volatile markets is a game of chicken you will lose! You MUST have an exit price predetermined and stick to your profit point!

After Closing the Trade, Build a New Trade!

The Risk Twist Spread is seldom used – but it is always needed.

That’s because the move you’re looking for, the big sell off, could happen at any time, and you can’t predict it. The day you forgo placing the Risk Twist Spread is the day the markets could sell off hard and fast – without you being on board.

Granted, such big sell offs are not an everyday occurrence. That’s why you have to position yourself well in advance, and be prepared to sit tight. Our aim is to find markets that are ready to get “smoked,” and be waiting with our Risk Twist Spread in place when we need it most. If we plan things correctly, the rewards can be big.

So don’t leave yourself without a Risk Twist Spread in place. When you close one, put in another one. To build a new Risk Twist Spread follow the initial entry criteria we discussed earlier.

Risk Twist Spread Odds and Ends

Now that you have learned the basics of the Risk Twist Spread, here are some final highly advanced ideas and notes.

Equity Risk Twist Spreads

You may be interested in putting on Risk Twist Spreads in equity products. If so, be careful to exit the trade 1 month prior to expiration.

Do NOT try to place a Risk Twist Spread with just a few days remaining until expiration because you’ve suddenly realized there’s an earnings announcement on the horizon. Always plan your trades in advance, giving yourself plenty of time.

In this case that means you had better know 90-130 days ahead of when the earnings announcements are coming! You can hold a Risk Twist through earnings, but exit 1 month prior to expiration!

Here are the charts of two equities, AAPL and GOOGL, that were ripe for Risk Twist Spreads:

You Can Also Be Bullish With a Risk Twist Spread!

We have focused on Bearish Risk Twist Spreads. However, you CAN create bullish trades using Risk Twist Spreads… although, in MOST products, as markets increase in price, their volatility decreases. As a result, the bang for the buck of a Risk Twist Spread is diminished when placed as a bullish trade.

Furthermore, you would need a 10% plus move UP in a product to see a profitable

Risk Twist Spread. And as we know, you’re more likely to see a quick, large move like that in a declining market rather than a rising one.

If you want to try a Bullish Risk Twist spread, we have found that products such as commodities and bonds can be viable for such trades as they often exhibit inverted volatility skews.We can see such an example in the Gold market:

Next Steps

Implement Risk Twist Spreads! Use what you’ve learned here. Practice with simulated trades if you feel more comfortable with that. But don’t lose sight of this excellent path to profit. Ease into this method, and learn it thoroughly before putting in larger trades. Trade small in the beginning (or better yet, implement simulated trades only) and realize the first few trades are about learning the concepts and dealing with the construction and execution of the Risk Twist Spread. Build your own Risk Twist Spread and get feedback on it. TheoTrade members can share their experiences in our exclusive, members-only chat rooms held Monday through Friday! Follow the TheoTrade trade ideas and track our trades in the TheoTrade Tracker – another benefit of TheoTrade membership.

To learn more about TheoTrade membership and its many advantages, call 1-800-256-8876 or email [email protected] and visit our web site at www.TheoTrade.com