This proxy for junk bonds is primed to collapse, but experimentation has taught us that it’s well nigh impossible to make money on weakness in JNK, even when pronounced, by simply buying put options. Near-the-money puts are priced in the stratosphere, sporting implied volatilities of around 21%. The underlying ETF, meanwhile, has a historical volatility of around 6%. Therein lies the problem: Buying puts would be like getting 4-to-1 odds on a horse with a broken leg.  The gate opens…and they’re off! Except for our nag, which must be removed from the track by a John Deere tractor. Well, okay, the metaphor is a bit overworked, but you get the idea:  Using put options to bet on JNK’s collapse, even when it is likely, is a sucker’s bet.

However, we can use an alternative strategy designed not only to reduce premium exposure, but to make a few bucks even if we are wrong.  Specifically, let’s try legging into an out-of-the-money calendar spread targeted on the 31 strike. That’s where I expect this sack of garbage to be trading six months from now. One-month at-the-money calendar spreads are trading for around 0.35.  Our goal is to start with a long position in June 31 puts; and then to sell short against them 31-strike puts in each successive month. If we short December puts that eventually expire worthless; and then Januarys; then Februarys, Marches, etcetera, we can conceivably take in more in premium over the next six months than we’ve paid for the Junes. We can easily do this if JNK slowly falls toward 31, since that would increase the value of the puts we will be selling short each month.  Ideally, come May, JNK will have fallen to 31 and we’ll be holding June puts worth 0.35 whose cost basis has been reduced to a minus number (i.e., a credit) by the premium we’ve taken in for puts sold short each month.

To get started, let’s test the water with a 0.25 bid for 60 June 31 puts, good till next Friday (November 13).  These options have yet to trade, but we may be able to force a trade by collectively putting up a “size” bid that attracts the interest of market makers. The puts are being reflected on a 0.20/0.50 spread, so our bid is pretty niggardly. If no puts come to us at that price, we’ll consider alternatives. If we get filled, it will be a great start for legging into cheap calendar spreads. Immediately thereupon, we would want to short December 31 puts for 0.05-0.10 against them, effectively legging on the initial calendar spread for 0.15 to 0.20. When those December puts expire, presumably worthless, we’d short 60 January 31 puts against our Decembers. And so on and so forth. Rinse and repeat. (For a detailed description of this strategy, click here to access the article I wrote on the topic for Stocks, Futures & Options magazine.)  _______ UPDATE (November 11, 10:29 p.m. ET): A nasty slide hasn’t budged the puts. Let’s raise the bid to 0.30 for now, just to let the market makers know we’re still there._______ UPDATE (November 16, 11:33 p.m.): We’ll chill for a while and wait for a rally, since this vehicle’s dive over the last two weeks has hardly been conducive to implementing our strategy.
_______ UPDATE (November 29): Shorting this flotsam every time it rallies 3%-4%  is as close to a sure thing as we could hope for in the trading world. An indirect way to do this is to go long in Treasurys; the worst way to do it is to buy puts.  If there’s interest in the chat room, I’ll look for set-ups and update as warranted.________UPDATE (December 9, 12:01 a.m.):  JNK’s ongoing collapse has vindicated my very bearish forecast. It also demonstrates how even unmitigated financial rubbish will tend to rally sharply enough from time to time to ward off bears intent on shorting it.