There is no doubt the market has run wild over the last month. And it looks like until some of the world and domestic news becomes more positive, this wild ride will continue. Sometimes the market swings 300 or 400 points in one day on the DOW. By swing I mean it may go up 150 points at the open then down to a negative 150 points on the DOW and that equals a 300 point swing. Then it may come back up to end in triple digits. So how do we take advantage of this?
Did I just hear you say you think the best solution is to run and hide during such a wild market? Well – don’t give up so fast. One way to play this market is by trading a Strangle on the SPY. The SPY is an ETF that mirrors the S&P 500 and pretty much represents the volatility of the entire market. Today I will detail how to utilize the Debit Strangle to take advantage.
A Debit Strangle can be accomplished by buying to open an out-of-the money Call and an out-of-the money Put on the SPY with the same expiration date. (This can be done on any optionable equity you think will have major swings in it.) But we are continuing our example on the SPY. As of the time of this writing, the SPY is trading at about $118.
But wait a minute you say! What if by the time I read this article it is trading at a different amount if it is November when I read this? Don’t get ahead here. Read on and you will see that the examples here can represent any price the SPY is trading at and during any month.
Let’s look at the options that are about 3 or four weeks out from today – the day you read this article. We could trade the weekly options if they are available for the underlying stock you chose to trade. They are always available on the SPY. But an option that is only 7 days out will have a higher Theta and therefore lose premium faster. So we want to go with options that will not lose the premium as fast. If it is the end of August, for example, we would be looking at the September monthly option with an expiration date the third Friday of the month. If it is September you would look at the October options, and so on.
So looking out at the next monthly options, I like the 120 Call, which is going for about $2.30, and the 116 Put is going for about $2.80 for a total debit of $5.10. Those options are out-of-the money by two strikes on both sides. You could experiment with further out strikes. Now the Put is more expensive, which means the volatility is higher in the Puts. Actually, with the market so wild the volatility in both options are high, making both option prices higher than normal. So we want to make this a short play. It might take a couple of days to get profit out of both, but as wild as the market has been it may take only one day. If you can make profit on both sides in one day – take it! We are always driving home the point that before you get into a trade, know your profit goal and exits. Now let’s say your goal is to make $.30 on each option for a total of $.60. As soon as one side makes the $.30 goal, sell – then concentrate on the other side.
When is the best time to go in? We like to buy these Strangles toward the close of the market for a next day play. If you think the volatility of the option could drop too much overnight, consider buying the Strangle right after the open on the day you plan to play it. But if you enter the trade toward the close of the day before, you can take advantage of the one side move, based on the gap the SPY makes at the open of the next day. For example, let’s say the SPY gaps up $.80 at the open the next day. In this market it can easily gap that much. What would the 120 Call that you bought before the close of the prior day for $2.30 be worth at the open then? Using the options calculator, theoretically it should be worth about $2.65. That gives you your $.30 goal plus some, so you could do one of two things at that point. Sell right away, or if it looks like the momentum will continue, watch for a while to increase your profit goal. But do not let it go on for long. If the momentum appears to be fading, sell.
That leaves you with the other side. If the market does what is has been doing and swings big in the other direction, you would watch it for that $.30 profit for that side. However, if you made more on the first side, you could sell for less to make sure you get out of the other side and make an overall profit. For example, let’s say you made $.50 on the first side. You were looking for a total of $.60 so you could sell the other side when it hits a $.10 profit giving you your goal. This is where you use your own discretion and creativity. But never get overly greedy. It usually backfires!
So what could go wrong with this play? The market, for whatever reason, could trade in a small range and not gap up or down much the next day. In that case, you could lose on both sides as most likely the volatility would start to drop bringing down both option prices. You would be wise to have a maximum amount in mind that you are willing to lose and cut the play if and when it hits that amount. The other thing that could go wrong is if the market gaps one way or the other and you make profit goal on one side, but then it keeps going in the same direction and never turns back. Here again, if that happens have a maximum amount you are willing to lose and sell the second option when it hits that point even if it means a loss. Remember, and I know this seems obvious, a small loss is better than a big loss.
Well, there you have it option trader. If you like this strategy and would like to get a lot more strategy ideas in option trading that increase the odds of making a profit while minimizing the risk, get a free preview of our new book! Never Let Wall Street Steal Your Money Again!!
Please note, this is in no way a recommendation from SplitMaster. The information presented here is only for educational purposes. While this play can be profitable, you should not attempt to make such a trade unless you have a full understanding of the type of option play you are making and understand well the possible outcomes and risks involved. If you are newer to option trading, consult your broker or financial adviser before making such a trade. And always paper trade a new strategy several times before making an actual trade.
Did you enjoy the article and understand the benefits? You did?? Great! Well, Tony Ponzo has a lot more of these types of ideas. Check out his newly published ebook, Never Let Wall Street Steal Your Money Again! The book is packed full of step by step instructions on the fundamentals of stock and option trading and has tons of option strategy ideas for every market condition. Get a Free Preview Also, send us your questions and comments to contact@splitMaster.com.