By Lynda Schuepp
As Julie Andrews sang in the Sound of Music, "Let's start at the very beginning, a very good place to start." This is my first time writing for Options 101, so I'm going to start at the beginning, but not at the very beginning. I'm assuming, if you are a subscriber, you know what a put and a call are, and the impact of volatility on the price of option. The tricky part is when the market is going sideways.
Plan your trade and trade your plan, great advice that I read somewhere. I know I couldn't have made that up, but I don't know who to pay homage to. Let's start at the beginning, namely the entry point. Of course, prior to entry, you should have done research on your stocks, technical analysis, studied which option strategies would be best suited for your outlook, and what your reward to risk scenario looks like. What you say? You don't know what your reward to risk is?
QQQ, which is representative of the Nasdaq 100, is one of my favorite trading vehicles. I trade the stock and the options. Note that the 50 day moving average of the prices has been steadily moving down with prices, no surprise here. Note also that the 50 day moving average on the volume has been moving up. What that tells us is that the smart money (the institutions) have been selling. However, the last 9 days shows that although prices are still moving down, the average volume is starting to go sideways, saying that the end is near! The problem will be that the QQQ's are likely to trade sideways before reversing direction and that is a much harder market to trade than a directional one. Option trades in this kind of a market would include butterflies and calendar spreads, which are more sophisticated and trickier to adjust. However, this is not a bad time to just buy the underlying and wait for a volatility spike to sell calls against your position. With volatility low, it might also a good time to be buying leap calls.
The Dow looks a little more promising. It was trading in a channel between October and the middle of December and then broke the channel. The Dow is establishing higher lows and finding a lot of resistance at 11,000, the magic number. A breakout to the upside may not be far away.
The OEX looks similar to the QQQ's. However, without a volume indicator it is difficult to determine if the end is near. From these three charts you can see that 2 out of 3 markets are down and one is sideways with a bias to the upside. Now are you still ready to jump in and load up the truck with short-term calls?
Looking at option prices above on the QQQ's from Friday's close and using the natural spread (buying at the ask and selling at the bid), I would look at the 55-60-65 call and put butterflies and the 60-65-70 call and put butterflies. Remember the maximum reward is if the stock closes at the middle strike at expiration. In order to determine which set of strike prices to use, you must determine where you think the stock will be on March 16th, option expiration day. The QQQ's are currently at $56.40 but I think they will be higher so I'd choose a middle strike price higher than Friday's close. Let's just look at one set of strikes for the calls and the puts, but you can use these prices to experiment on your own and find a trade that you would feel comfortable with.
Looking at the March 55-60-65 calls
Looking at the March 55-60-65 puts
Odds are better using the call scenario in this case. If the QQQ's drop further, you could buy back your 60 calls and let your long calls ride for an almost free trade. Using calls, you would make money if the QQQ's close between $56.10 and $63.90 by March 16th, which is a pretty nice range. If you were VERY bullish you would move the butterfly up and use the 60-65-70 strikes, but that would mean your expectations would be for the QQQ's to close up 15% to $65 by expiration. There is not a magic bullet here, just a scenario you can work at to get better.
If you've never traded butterflies, paper trade these two scenarios, or one that you like better and see where the QQQ's and the butterfly close daily, weekly and at expiration. It's a great strategy, with low risk, high reward and let's you sleep comfortably at night. Once you understand how this trade moves relative to the underlying, you just might find this to be your favorite strategy.