Sideways Market Options

In case you’ve been hiding in a remote barn for about the last six months, away from all civilization, I’m reluctantly going to inform you that we are in a sideways market. This is not only one of those markets that tests your skills as a trader, but will test your patience as well.

These days, it seems that no matter whether the markets are up, down or flat, all day long I hear the same television commentary. The floor traders and analysts alike are all commenting on the fact that very, very few companies are able to provide any kind of near or long term guidance. We’re not even seeing as many comments any more about a pick up in the last quarter. And with that, we have investor indecision. Institutions as well as individuals aren’t buying, yet they’re not exactly dumping stocks anymore either. So with all this skepticism and lack of confidence, how in the world do we successfully trade this market??

Believe it or not there are a couple of options here:
1.Stay out of the market altogether.
2.Play managed-risk sideways strategies that involve selling premium.
Okay, so you don’t want to stay out of the market if you’re trying to pay bills with your trading. But the first thing that you will have to accept is that the money isn’t coming in as fast and furious as it has over the last few years. Sadly, this trend will most likely stick around for a while.

The solution however is pretty simple—when the markets don’t move, you can choose option #2 and think SELL. Almost any spread in which you can sell premium for a credit to your account can be viewed as a sideways strategy. The trick can be in understanding why. As it happens when playing directionally, you make money only when the stock you’re playing moves in the direction you’ve chosen. And even if the stock does move in the right direction, your option play could still lose if the move doesn’t occur fast enough due to time decay. When you sell time, you don’t need to pick a direction, and time decay works for us, not against us. In fact, you can even remain profitable if the stock moves a little bit in the wrong direction! I’ll explain using long calls and credit spreads as examples.

Suppose I think that the tech stocks have bottomed out here with the Nasdaq 100 tracking stock (QQQ) trading right around $40 a share. I look at my choices and see that I can either purchase the August calls or place a bull put credit spread and put cash in my account right away. As a reminder, a bull put spread combines the purchase of a lower strike put and the sale of a higher strike put against it for a credit to your account. The trade is profitable if at expiration, the short put expires for less than the credit taken in. As of the close on 7/24/01, the August $40 calls are going for $2.25 (or $225 per contract). Now, I look to see how much I can get from an August 38/40 bull put spread (in which I would buy the $38 puts and sell the $40). As of the same close, I can receive $.60 per spread. This may not seem like much, but 60 cents on a $2 spread is a 30% profit. As long as the Q’s trade above $40 a share at expiration, I get to keep the entire credit. In order for me to just breakeven on the calls at expiration, the Q’s need to finish at $42.25 (40 + 2.25) compared to the $39.40 finish line for the credit spread (40-.60=39.40). Furthermore, in order to just make the same 60 cents as the credit spreads, the stock needs to finish at $42.85.

Sounds pretty good so far huh? Now one of the first things you may be asking if you’re a skeptic is, “Why would I want to limit my profit potential when for only $225, I can make an unlimited amount of money on the calls alone?” The answer lies in the probabilities. If you look at a chart of the Q’s, you’ll see that we’ve had lower highs since the middle of May; we haven’t been able to jump through $45 for over a month now. Therefore, what are the odds of this supposed “unlimited reward” even happening in the first place? We have to assume that even though historically the risk/reward ratio is certainly better for a long call than a credit spread, the actual probability of the former becoming profitable is not as good as the latter. Hence, credit spreads need to be looked at a bit differently than other types of plays. The following chart gives us a better view of what I mean.

As you can see, provided we have set up the play correctly, the credit spread has over a 66% of succeeding, whereas the long call play has less than 33%. Both plays are bullish in nature, but the credit spread leans toward a conservative stance with a better chance of survival if you are wrong with your choice of direction.

The other advantage of the credit spread is the maximum capital you’re putting at risk compared to the long call. The maximum risk on the trade is equal to the difference between the strikes minus the credit received. In this case the risk is $1.40 (or $140 per spread) versus the $2.25 at risk on the calls.

In a nutshell, devising trades that involve the selling of premium with limited risk spreads during slow times—such as the one we are currently faced with—can offer higher probabilities at lower costs, with even lower breakeven points. Credit spreads are just one of many choices. Calendar spreads are another option. Yes, it’s true that we won’t hit as many “homeruns” this way; but there’s a pretty good chance we won’t strike out as much either. And I’ll take a consistent series of base hits over consistent losses any day in this ballpark. (Besides, whoever said that 30% in less than one month isn’t a home run anyway?)

Until next time.