Playing the Range

Following their earnings reports many stocks may be stuck in range for the next few months. Here’s an option strategy to collect income while waiting for the next big move. 

Most people think of and use options to as a tool for directional trading. You buy a call if you think a stock is going up, or you buy a put if you think a stock is going down.

But for the directional trade to work you must not only be correct about the direction of the stock, the price level it will get to, which will determine the strike price you need to choose and the time frame it will achieve the target. You also have to be aware of the option’s implied volatility, the great variable which heavily influences value of the options and can impact the trades probability of realizing a profit.

That is quite a few decisions to make before placing a directional risk trade. Of course, the more decisions you have to make, the easier it is to make an error. The more decisions you can take out of the equation, the better your odds of a profitable trade.

Non Directional Trades

It is also a well-known adage that 80% of all directional options trades expire worthless. That means the person that sold the option and collected the premium is the winner 80% of the time. If you knew nothing else wouldn’t you want to be on the team that wins 80% of the regardless of how the game plays out? That is, you win whether the stock moves up or down as long as it stays within a reasonable range.

This is called non directional trading, and it lets you profit from option premium decay over time. The main strategy employed is called an iron condor and involves the simultaneous selling of both a put spread and a call spread for a net credit. The profit is limited to the amount of premium collected and the potential loss is limited to the width between strikes. We look at the details of a specific trade below.

First, let’s go through some start with the advantages of this strategy and how you go about structuring the trade so you have a high probability of success.

For starters you want to choose a stock with no immediate news event, such as earnings, pending mergers or pending regulatory rulings such as FDA approval of a drug. Given earnings come out on a regular three-month cycle, one we are passing through now, it’s easy to set up an iron condor using expiration dates that avoid these have price moving catalysts. Of course you can’t control unforeseen black swan events or macro events such as Central Bank intervention that can cause large swings in the entire market. But iron condors do a great job of navigating choppy waters and limiting risk.

Let’s walk the process of setting an iron condor in Alphabet (GOOGL). For starters, the company recently reported earnings on April 21 that caused shares to gap down below $755 and tumble in the ensuing days to a low of $709 before rebounding back towards $725-730 level.

GOOGL Chart 4.28.16

The chart with support and resistance levels of $700 and $755, which also represents the 200 and 100 dma respectively, as range in which we can expect shares to stay within for the next month or two. This will help us choose the strike prices structuring our iron condor.

Now take a look at the options chains. Start with the weekly chains, and see how much premium you can get for a spread that is $10 wide with the strikes you are selling starting at $700 and $755. The weeklies only offer a total credit of just $2.00 meaning we’d be risking $8. So let’s look out the monthly options that expire on May 20.   There we can get a $4.00 net credit.

Here is how the trade would set up.

-Buy to Open May 690 Put

-Sell to Open May 700 Put

And

-Sell to Open May 755 Put

-Buy to Open May 765 Put

For a $4.00 net debit.

This is what the order and risk graph looks like.

GOOGL Iron condor risk 4.28.16

As you can see as long as shares of GOOGL are between $700 and $755, a near 7% range, at the May 20 expiration you keep the full $4.00 of premium. On the other hand your loss is limited to $6 if shares were to close below $690 or above $765 at the expiration. You can always reduce the risk further by closing the position early if those levels are violated.

The overall numbers for this trade could provide a 65% return on risk within a bit less than one month. All for doing nothing but watching shares of GOOGL meandering around with a range.

— Steve Smith

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About the Author: Steve Smith