It feels like we may be almost there. To a bottom I mean. There's been more bad news out there but yet the markets haven't been selling off quite as hard as it has in the past. True, we've come down a long way and there's not much more room to fall for some stocks. I believe it's a good sign that we rally in the face of more negative news. Even after the Cisco warning yesterday, the markets are hovering around unchanged today. Three months ago, we would've been down triple digits.
As the market may be forming a base here, it wouldn't be unlikely for it to trade in a range for awhile until it gets a strong foothold and decides whether to start moving up or if we haven't seen the bottom yet. Either way, I feel we are in for some contained swings, so I'd like to discuss some strategies to take advantage of what may lie ahead.
Since the markets may trade in a range, we'll discuss limited risk, limited reward, option-selling strategies that will put time decay and high implied volatility on our side. Condors and Butterflies are the name of the game. Since we want to trade the broad markets, we'll can use the OEX and SPX as our key indices. And since we feel we're rangebound, we will sell both calls and puts at the same time.
Butterflies and Condors take on a similar setup except that one uses a straddle vs. strangle approach and the other uses two strangles. Some people classify the "Iron Butterfly" as a straddle vs. a strangle and others classify the condor as a strangle vs. a strangle or dual credit call and put spreads. No matter how you slice it, these two strategies are used for rangebound trading.
Here's what we have: Index XYZ is at 300. You believe we're in for some wide swings over the next month. Since we'll be selling the spreads, we want to concentrate on the front-month which will give us the best time decay activity. We'll start with a condor using the May XYZ options:
- May XYZ 275 put @ 3.10
This condor receives an initial credit of 3.36 points ($336) into the account. Since the range between the strike prices is 10 points, the most we can gain is our initial credit of 3.36 points and our maximum loss is 6.64 points (10 - 3.36). You can see that this strategy can be classified as either a dual credit spread consisting of the 265/275 put credit spread and the 325/335 call credit spread. Or it can be looked at as the 275 put/325 call short strangle vs. the 265 put/335 call long strangle. Either way, the results are the same. Here's a graph of the profit/loss scenario at expiration.
You can see we have a pretty wide range of profitability with this condor. As long as XYZ index stays between 271.64 on the downside and 328.36 on the upside, we'll show a profit.
An Iron Butterfly, on the other hand, would be used if you really had a good feeling about where the index would end up. We would collect a larger premium upfront, but the area of profitability is smaller. Let's use the same index but with different strikes.
- May XYZ 300 put @ 11.83
The Iron Fly has an initial credit of 8.63 points, which is our maximum gain and only has a maximum loss of 1.37 points. Here's the graph:
We have a narrower profit range which is between 291.37 and 308.63, but that is made up for by giving us a larger initial premium. I like that risk/reward ratio. Even it the market does move out of our range, the loss is capped at $137.
The condor and butterfly can also be used with either all calls or all puts (it won't be called an Iron Fly anymore, just a regular Butterfly) and doesn't have to be centered around the current price of the underlying. You can use calls or puts above or below the market which can give you a more bullish or bearish spin on the trade. If you have a software program that can graph the P&L ranges, it's quite helpful to see it visually.
If you feel we are rangebound in any type of market, these are two of the best strategies to employ.