Variations on a Theme - "Risk Reversal"

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The market has rallied hugely since the bottom in 2009.  It was due for a correction, and the "excuse" for such correction (selling) came from the Libyan mayhem and the Japanese earthquake and tsunami of March 11, 2011.  In a matter of a couple of weeks, the market gave back about 8% of its value. 

I trade stocks and options that are concentrated in the NASDAQ.  The proxy for the NASDAQ is the stock QQQQ (Q's).  The Q's closed at $54.45 on March 18, 2011.  I believe that if the current price holds, it will represent a floor or support to the current price, which should stabilize and climb from here.  Here is a way to create a bullish Risk Reversal on the Q's:

Buy to open 2012 $55 strike calls = ($4.60)

Sell to open 2012 $60 strike calls = $2.26

-and-

Sell to open 2012 $50 strike puts = $3.47

NET CREDIT $1.13

This is a position where you BUY-SELL-SELL.  What does this position do?  If the Q's rally from here, the OTM call spread will increase in value, and the OTM put will expire worthless.  The Q's would have to remain above $50 in order to collect the entire premium of $3.47, and would have to rally to at least $57.34 just to break even on the Bull Call Spread ($55-$60).  If the Q's merely remain above $50 by expiration in 2012, my entire profit will be $1.13. 

Let's go deeper in the money. 

BTO 2012 $50 calls=($7.69)

STO 2012 $52 calls=$6.22

-and-

STO 2012 $50 puts=$3.45

NET CREDIT $1.98

In this scenario, I have created a Bull Call Spread with strikes that are in the money (ITM) that cost me $1.47 for the potential to make $2, while simultaneously selling a naked $50 put.  What I am expecting is that the Q's will not only remain above $50 by January of 2012, but will, in fact, remain above $53.47 ($52 higher strike call+premium paid) in order to at least recover my outlay for the spread.  The margin requirement for this position is listed as $791.  This means that my ROI would be 25%. 

If overnight there are some terrific news that push the entire market up, I might simply "leg into" this position.  For example, I might BTO the 2012 $50 Q's calls for $7.69 and STO the 2012 $50 puts for $3.45 for a DEBIT of $4.24, and wait for a rally before selling the $55 calls to create the Bull Call Spread. 

Another possibility is to use the above Net Credit of $1.98 to purchase as many OTM calls as I can to participate in an upside.  For example, the April 2011 $56 calls are currently fetching $0.72, therefore, I might BTO 2 contracts for $1.44.