Not Sure Where The Market Is Headed? Here's How The Pros Play It...
Being an options professional, I've executed just about every option strategy that exists.
But for the mainstream investor, I feel it's only wise to use (and understand) a handful of option trading methods. All the others are better suited for, and utilized, by floor traders, hedge funds, and other big institutional firms.
Two conditions exist in the market right now that are ripe to execute a simple, yet effective, option trading strategy that can take advantage of the market moving in either direction.
On The Fence? Let's Discuss
Condition #1 - the market's current price.
With the Dow Jones, Nasdaq Composite & the S&P 500 once again flirting with all-time highs, there are many people cheering the move. Heck, if you have a stock portfolio, you're a happy camper right now.
But there's also the camp that are bemoaning this move, most likely because they sold during last December's melt-down, and have missed the entire run back up.
All you need to do is look at a chart of the S&P 500 to see how strong the bounce has been since December.
Although the jealous naysayers are licking their wounds for selling too soon, there is a case being made that stocks are just too expensive here and ripe for another pull-back.
The gloom & doomers think that the large U.S. debt, the tariff stand-off with China, slowing corporate profits, the yield curve inversion, and a multitude of other issues are sure to sink the market.
On the brighter side, we have the bullish camp which thinks that it's full steam ahead for the market. Momentum is on their side.
And with the Federal Reserve recently signaling that interest rates will be lowered, the bulls feel even more emboldened. You know the sayings - "the trend is your friend" and "don't fight the Fed" .
So the market could be at a critical juncture right here, and it's easy to see both sides. Who's right?
Condition #2 - option prices are cheap.
In the option trading world, option prices are measured as cheap or expensive not by their actual dollar cost, but by their "volatility" level.
We can clearly see from this chart of the VIX, that options are very cheap at the moment compared to the past.
As a refresher, the VIX is a volatility gauge of the broader market (as measured by the S&P 500), and it signifies whether option prices are overall better for buyers or sellers. The VIX is signifying that if you are an option buyer, now could be a good time to strike.
If the VIX was high, option-selling strategies would be the trade du jour.
Although buying options when they're cheap can put you at an advantage, it's still only one part of the equation. You still need to have a directional opinion on the stock in which to base your option-buying method.
But what if you're undecided on the direction?
Enter, the "Straddle"
One of the easiest ways to use options when you're undecided on the direction of a stock is to buy a straddle.
A straddle entails buying both a call option and a put option of the same strike price within the same expiration month.
The thinking goes - if the stock moves big enough in either direction, the gain on the profitable option will outweigh the loss on the unprofitable option.
Buying a call option is a bullish strategy while buying a put option is a bearish strategy. You're essentially "straddling" the market by playing both directions at the same time. Genius!
For example, the SPY is one of the most popular exchange-traded-funds that mimics the move of the overall market.
With its price hovering near $292.30 per share, you're convinced that it's going to have a large move within three months, but just not sure in which direction.
Buying a straddle can help alleviate that dilemma.
Let's see what it costs.
Based on the option chain above, an investor could look at buying the September 30, 2019 $292 strike straddle (hypothetical trade) since its strike price is closest to the current price of the SPY.
It can be bought for a total cost of $17.12 per straddle (splitting the bid/ask quote), as the call would cost $9.15 per contract and the put would cost $7.97 per contract. With the $100 option multiplier, that would entail a total dollar cost of $1,712 per straddle.
The actual trade involves buying both the $292 call option and the $292 put option at the same time. You wouldn't need to buy each separately though, as both can be transacted in one single shot. In option lingo, that equates to buying the $292 straddle.
For the next three months, the trade would cover you if the market moved big enough in either direction.
Profit & Loss Potential?
If you've ever bought options contracts before, there's an easy way to figure out where the break-even points lie.
All it takes is adding (and subtracting) the option's cost to the strike price.
In this case, since the straddle costs $17.12 per, you would need to add and subtract that amount to the $292 strike price to find the upside and downside breakeven points.
On the upside, the breakeven point is $309.12, and on the downside, the breakeven point is $274.88.
As long as the SPY moves either above $309.12 or below $274.88 by September expiration, the trade will turn a profit.
How much? That depends on how far the SPY moves above or below the breakeven thresholds. Theoretically, the profit potential is unlimited.
What about risk? When buying options, the maximum risk is never more than what was paid.
In this case, it would be $1,712. In order to sustain the maximum risk, the SPY would have to close exactly at $292 at September expiration. If it closes anywhere between $274.88 to $309.12, then there will be varying degrees of loss.
The key to making a profit with buying straddles is to have confidence that the stock can make the move beyond the breakeven points in the allotted timeframe.
One piece of advice - if the move happens quickly, it's advisable to take profits when they're there. The stock can always reverse direction and give away the gains. You're always fighting the clock when buying options, so taking gains quickly is necessary.
A visual chart like the one above is always helpful to see how the trade can look at expiration.
The V-shaped chart shows maximum loss at expiration if SPY closes at $292 (straddle strike price). The loss gets smaller as SPY moves towards either downside or upside breakeven levels. And unlimited profit potential is seen as SPY extends in either direction.
In conclusion, if you know a big move is coming but not sure in which direction, a straddle can be your best friend. Just make sure volatility is cheap and take those profits when available.
Until next time...