Option Investor
Educational Article

The Hills Are Alive With The Sound Of Music

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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?

Step 1:
What is your market outlook and is your stock following the trend? That trite, but tried and true saying, "the trend is your friend" should be followed whenever possible. When I analyzed my losing trades from last year, I found that most of them occurred when I fought the trend. Most salmon die trying to swim upstream, so why fight it? Below are charts of the Nasdaq 100, Dow Jones and the OEX, which I use to gauge the trend of the overall market. Note that you can't get volume from OEX charts. Look at the direction of the 50 day moving averages as they appear on each chart. It's easy to spot the trends. When price and volume averages are moving in the same direction, you can expect more of the same, if they are moving sideways, you can expect a choppy sideways market but look out if they are moving in opposite directions.

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?

Step 2:
Determine an appropriate option strategy. Based on my analysis of the market, we are headed sideways. I like butterflies in sideways markets so I am looking at stocks that will provide a nice risk to reward. Sideways markets are uncertain and there is no way to gage how long they will last. I like to go out only a month or two. Next, I would look at the cost of the puts versus the calls to determine which is cheaper. As a review, you pick a strike and buy one option then go up and sell two options at a higher strike price and then finally go up again and buy one option. There is no additional margin required, and your risk is the cost of the butterfly.

Step 3:
Determine your risk to reward. The risk in a butterfly is the cost of the spread. The reward is the difference between the middle strike and outer strike less the cost of the spread.

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
55 call-- debit is 4.90, 10 contracts cost $4990
60 call-- credit is 2.50, 20 contracts you'd get $5000
65 call-- debit is 1.20, 10 contracts cost $1200
Total cost of the butterfly would be $1100 (4990 less 5000 plus 1200)
Maximum reward is $3900 (middle strike less cost of butterfly)
Maximum risk is $1100 (cost of butterfly)
Reward to risk is approximately 3.5 to 1 ($3900/1100)

Looking at the March 55-60-65 puts
55 put debit is 3.10, 10 contracts cost $3100
60 put credit is 5.70, 20 contracts you'd get $11400
65 put debit is 9.60, 10 contracts cost $9600
Total cost of the butterfly would be $1300 (3100 less 11400 plus 9600)
Maximum reward is $3700 (middle strike less cost of butterfly)
Maximum risk is $1300 (cost of butterfly)
Reward to risk is approximately 2.8 to 1($3700/1300)

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.


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