THE OPTIONS COURSE- Trading Techniques for Range-Bound Markets

THE OPTIONS COURSE


Trading Techniques for Range-Bound Markets

large percentage of markets trend sideways within a consistent trading range throughout the trading year. In many cases, you may find stock shares or futures that have been trading sideways for some time. While these markets do not produce much in the way of profits for the traditional buy-and-hold stock trader, they do provide options traders with amazing limited risk opportunities. As previously discussed, option pricing includes time value and intrinsic value. The intrinsic value of an option is the value an in-the-money (ITM) option has if it were exercised at that point. For example, if I own an IBM 70 December call option, and IBM is trading at $80, the option has $10 of intrinsic value. 

This is due to the fact that the strike price of the call option is below the current trading price of the underlying asset. If the option has a market price of $12, then the remaining $2 of the call option is the time value. Furthermore, if an IBM 90 put option costs $13, it would have $10 of intrinsic value and $3 of time value. Intrinsic value is not lost due to the passage of time. Intrinsic value is lost only when the underlying asset—in this case IBM—moves against your option’s position. In this example, if IBM moves down, the call options lose intrinsic value. If IBM moves up, the put options lose intrinsic value. 

Time value is lost due to time decay (also referred to as the theta decay) of the option. Options lose the most time value in the last 30 days of the life of the option—the closer the expiration date, the faster the theta decay. Therefore, the last day will have the fastest loss of value due to time. Since options lose value over time if markets do not move, this basic option characteristic can be used to create strategies that work in markets that are moving sideways. Before we can explore the specific strategies, however, you need to be able to spot a sideways (or range-bound) market. 

A sideways market is a market that has traded between two numbers for a specified period of time. The minimum time frame I prefer to use is two months. However, for our purposes, a longer time frame can mean a more stable sideways market. As previously reviewed, these two numbers are referred to as the support and resistance levels. For example, if every time IBM dips to around $70 per share it rebounds, this would establish the support. If IBM would then trade up in price to reach $90 and then sell off again, this would establish the resistance. These two levels can then be used to employ an effective options strategy that would allow us to collect time premium. 

How do you find these range-bound markets? I like to scan the various markets by eyeballing the charts. If I spot a market that appears to be going sideways, I take a ruler and try to draw a support and resistance line. If this is easily accomplished, I then look for the most effective options strategy to take advantage of the given market. Three of my favorite sideways strategies are the long butterfly, long condor, and long iron butterfly spreads. Additionally, we will also explore three more advanced range-trading strategies: the calendar spread, the diagonal spread, and the collar spread.

LONG BUTTERFLY

The long butterfly is a popular strategy that traders use when they expect the stock or market to trade within a range. The butterfly can be structured using calls, puts, or a combination of puts and calls. In that respect, the long butterfly includes three strike prices and can be thought of as a combination of a bull call spread and a bear call spread. Lower and middle strike prices are used to create the bull spread and middle and higher strike prices are used to create a bear call spread. 

Sometimes, traders refer to the middle strike prices, which are generally at-the-money, as the body and call the higher and lower strike prices the wings.  The long butterfly is a limited risk/limited reward strategy. It works well when the underlying stock makes relatively little movement. The strategy generates the maximum profits when the price of the underlying asset is equal to the strike price of the short options at expiration. The risks arise when the underlying asset moves dramatically higher or lower. However, the maximum risk is equal to the net debit paid for the trade.

For that reason, the strategist will implement the long butterfly when expecting the underlying asset to stay within a range until the options expire. As a side note, although we will be using calls in our next example, the long butterfly can also be created using puts. In this case, the strategist will establish the position by purchasing one OTM put (wing), selling two ATM puts (body), and buying one ITM put (wing). This would be a combination of a bull put spread and a bear put spread. 

Some strategists prefer to use the so-called long iron butterfly, a trade that is created as a combination of a bear call spread (a short ATM call and a long OTM call) and a bull put spread (a long OTM put and a short ATM put). The short put should have a lower strike price than the short call. Therefore, unlike the long butterfly, the iron butterfly includes four strike prices instead of three. In any case, whether trading long butterflies with puts and calls or trading long iron butterflies, the goal is to see the underlying stock trade sideways and for the short options to lose value due to time decay and expire.

Long Butterfly Mechanics

To illustrate, let’s consider an example using a hypothetical company, XYZ. During the month of January, shares are trading for $70 and have been trading in a range between $65 and $75 during the past several months. So, the strategist believes the stock will remain within that range and gravitate toward $70 from now until May expiration. As a result, a long butterfly is created using calls on XYZ.

In this case, the strategist goes long one May XYZ 65 call for $8, buys one May XYZ 75 call for $2, and sells two XYZ 70 calls for $4.50 each. The net debit of the trade is $1, or $100 for one long butterfly, which also represents the maximum risk. The maximum reward is equal to the difference between the middle and highest strike prices, minus the net debit times 100. In this example, the maximum profit equals $400 [(5 – 1) × 100 = $400] per contract. This will occur if the XYZ is trading for $70 a share at expiration. 


FIGURE  Long Butterfly Risk Graph

Exiting the Position

• The underlying asset falls below the downside breakeven (66): The strategist will generally want to let the options expire worthless and incur the maximum loss.
• The stock is in between the breakevens (66 and 74): The trade is in the profit zone and the strategist should let the short options expire. If possible, sell the long option with a lower strike price for a profit.
• The stock makes a dramatic move higher than the upside breakeven (74): Exit the position or, if the short options are assigned, exercise the long options to offset them.

Long Butterfly Case Study

A long butterfly is a strategy best used when a trader expects sideways movement in a stock or index. A long butterfly can use either all calls or all puts and is the combination of two spreads. If calls are used, we are combining a bull call spread and a bear call spread. For puts, it is the combination of a bull put spread and a bear put spread. The idea of the butterfly is derived from the purchase of the “wings” of the trade and the sale of the “body.”

A butterfly is a limited risk, limited reward strategy. The initial entry fee into a butterfly creates a net debit, which is also the maximum risk of the position. The maximum reward is calculated by subtracting the net debit from the difference between strike prices. For example, if we enter a 35-40-45 call butterfly, we would buy a 35 call, sell two 40 calls, and buy a 45 call. If our net debit was $3, our maximum risk would be $300 and our maximum reward would be $200: (5 – 3) × 100 = $200. The maximum profit occurs if the underlying security closes at the middle strike price at expiration. 

In mid-October 2003, a trader might have looked at IBM and expected it to trade sideways through November’s option expiration on the 21st. On October 16, IBM closed at $89.28 and it seemed likely that the stock would consolidate near $90 after a significant decline. As a result, we could have entered a butterfly using the 85-90-95 put options or call options. However, let’s use the calls because they offered just a slightly better entry. Since this trade benefits from time erosion and because we don’t want to give the stock too much time to move out of its range, it’s usually best to use front month options when trading a butterfly.

The November 85 call could be purchased for $5.20. The 90 calls could be sold for $2. The 95 call would cost 0.60, leaving us with a total debit of $1.80. Let’s say we decide to place a total of five contracts; the net debit would be $900, which is also the maximum risk. The maximum profit is found by subtracting the debit of 1.80 from the difference in spreads (5 points) to get $320: (5 – 1.80) × 100 = $320. Thus, if IBM were to close at $90 on expiration, the maximum profit of $320 per contract, or $1,600, would be achieved from an initial $900 investment.

The risk graph also points out that the maximum profit is impossible to achieve until expiration. This strategy rarely sees a trader get out with a profit at the beginning of the trade. This is because a butterfly benefits from time erosion. We normally would like to see at least a 2-to-1 reward-to-risk ratio when trading a butterfly. For this trade, our reward-to-risk ratio was about 1.8 to 1, but we could have easily gotten a 2-to-1 ratio by getting a price somewhere between the bid and the ask.


FIGURE  Risk Graph of Long Butterfly on IBM 

IBM shares did indeed trade sideways through November expiration, closing at $88.63 on November 21. This left the trade with a profit of $180—a 100 percent return—which is calculated by taking the value of the long option ($180) and subtracting any options that had to be purchased. However, no additional options had to be purchased because the 90 options were out-of-the-money at expiration.

LONG CONDOR

Like the butterfly, a condor is composed of a body and wings. In the case of the long condor, the wings are composed of two long options—one in-the-money and one out-of-the-money. The body includes two short inner or middle options. Again, this type of strategy works well when the strategist expects the stock or market to remain range-bound. Most often, the long condor is constructed using four strike prices. For example, a strategist might buy one in-the-money call, sell two calls with different strike prices, and buy one deeply out-of-the-money. Since this trade involves four separate options contracts, managing commissions is an important aspect of this trade—the lower the commissions, the better.

The goal of the long condor is to see the short options expire worthless, but also see the in-the-money option retain most of its value. The maximum potential reward is calculated by subtracting the net debit of the trade from the difference between the strike prices. If the underlying security makes a dramatic move higher or lower, the long condor generally yields poor results. The upside breakeven is equal to the highest strike price minus the debit. The downside breakeven is equal to the lowest strike prices plus the debit. The maximum risk associated with this trade is limited to the net debit.

Long Condor Mechanics

In order to see how the long condor works, let’s say XYZ is trading form $66.40 a share on May 10. We expect the stock to stay within a trading range of $65 and $70 a share for the next several months. Consequently, a long condor is examined using October call options. To create the trade, we first go long one October XYZ 60 call at $8 and long one October XYZ 75 call at $1. Next, we go short the October XYZ 65 call at $5 and short the October XYZ 70 call for $2.

The net debit on this trade is $200, which is also the maximum risk. The maximum reward is equal to the difference between the strike prices minus the debit, or $300 per contract: [(75 – 70) – 2] × 100 = $300. The upside breakeven equals the highest strike prices minus the net debit, or 73 (75 – 2 = 73). The downside breakeven is computed as the lowest strike price plus the net debit, or 62 (60 + 2 = 62). Ideally, with this trade, the strategist will see the short options lose value, but the deeply-in-the-money call will retain its value. 

For instance, if the stock price is equal to $65 a share at expiration, the only option with any remaining intrinsic value will be the October 65 call. In that case, three of the options expire worthless, but the October 60 call is worth $5. The October 60 can then be exercised or closed. If so, the net profit from the trade will be the profit earned from the October 60 call minus the debit.

Exiting the Position

Exit strategies for the condor are similar to the butterfly spreads.

• XYZ falls below the lower breakeven (62): This is the maximum risk range for this trade. The strategist will probably let the options expire worthless and incur the maximum risk. Make sure to salvage any remaining value of the October 60 call if the stock price is below $62, but above the October 60 strike price at expiration.
• XYZ remains between the downside (62) and upside (73) breakevens: Ideally, the stock price will fall near the strike price of the first short option at expiration. Let the out-of-the-money options expire worthless and close the positions involving the in-the-money-options.
• XYZ rises above higher breakeven (73): Close the position to avoid assignment and incur the maximum risk.


FIGURE  Long Condor Risk Graph

Long Condor Case Study

A condor is similar to a butterfly, but this strategy widens out the maximum reward. A condor is still a sideways trading strategy that takes advantage of time erosion. Choosing between a condor and a butterfly has to do with the range the stock is expected to trade and the risk graph. Remember, a butterfly has a maximum profit at a specific price. A condor has a maximum profit across a range of prices. A condor is a limited risk, limited reward strategy. The initial entry into a condor creates a net debit, which is also the maximum risk. 

The maximum reward is the difference between strikes less the initial debit. For example, if we enter a 30-35-40-45 condor, we would buy a 30 put (call), sell a 35 put (call), sell a 40 put (call) and buy a 45 put (call). If our initial debit were $2, our maximum risk would be $200. The maximum profit occurs if the underlying security closes between the two sold strikes at expiration. This is the main attraction of a condor, as it has a larger maximum profit zone than a regular butterfly. However, the risk also increases with the added reward.

As in the long butterfly case study, in mid-October 2003, a trader might have looked at IBM and expected it to trade sideways through November’s option expiration on the 21st. On October 16, IBM closed at $89.28 and it seemed likely that the stock would consolidate near $90 after a significant decline. As a result, we could have entered a condor using the 80-85-90-95 put options. All calls could also be used, with the best reward-to-risk ratio being the one that should be used. Since we benefit from time erosion and because we don’t want to give the stock too much time to move out of its range, it’s normally best to use front month options when trading a condor.

The November 80 puts could be purchased for $0.30, with the 85 puts selling for $0.90. The 90 puts could be sold for $2.80, with the 95 puts costing $6.50. This created a debit of $3.10 per contract, with five contracts for a total of $1,550, which is also the maximum risk. The maximum reward is calculated by subtracting the net debit from the difference in strikes (5 points). In this trade, if IBM were to close anywhere between $85 and $90 on expiration, the maximum profit of $190 [(5 – 3.10) × 100 = $190] per contract, or $950 (5 × 190 = $950), could be kept. 

The breakeven points were at 83.10 and 91.90 and are found by taking the net debit of $3.10 and adding it to the lower strike for the downside breakeven: (80 + 3.10 = 83.10). The upside breakeven is found by subtracting the $3.10 debit from the higher option strike: (95 – 3.10 = 91.90). Notice how the risk graph shows the trade’s limited reward and limited risk. The risk graph also points out that the maximum profit is impossible to achieve until expiration. This strategy rarely sees a trader get out with a profit at the beginning of the trade. 

This is because a condor benefits from time erosion. We aren’t going to see as high a reward-to-risk ratio trading a condor as trading a butterfly, but our maximum profit is more likely to be achieved because of the wider maximum profit range. IBM shares did indeed trade sideways through November expiration, closing at $88.63 on November 21. This left this trade with the maximum profit of $950. If the stock had closed above 95 or below 80, the maximum loss would have occurred.


FIGURE  Risk Graph of Long Condor on IBM 

LONG IRON BUTTERFLY

The long iron butterfly is another strategy that works well in range-bound markets. It’s actually a combination of a bear call spread, with (a short ATM call and a long OTM call), along with a bull put spread (a long OTM put and a short ATM put). The short put can have a lower strike price than the short call. Therefore, unlike the long butterfly with only puts or only calls, the iron butterfly includes both puts and calls, as well as four different options contracts instead of three. To structure the trade, the strategist will buy an OTM call and an OTM put. 

At the same time, they will sell an ATM call. In general, the short call will have a strike price in the middle of the stock’s recent trading range. Finally, an ATM or slightly OTM put is also sold. In contrast to the long butterfly, which is established for a debit, the iron butterfly is done for a credit because the strategist is buying two out-of-the-money options and selling two at-the-money options. Both the risks and the rewards of the long iron butterfly are limited. The success of the trade depends on the stock staying in between the upside and +downside breakevens. 

The upside breakeven is computed as the strike price of the short call plus the net credit received for the trade. The downside breakeven is equal to the short put strike price minus the net credit. The maximum reward is the total credit received on the trade. The greatest risk is equal to the difference between the strike prices minus the net credit. Also, importantly, since this trade involves four contracts, the commissions can be significant. For that reason, although the risks are generally limited, keeping commissions low will greatly improve the reward potential of the iron butterfly trade.

Long Iron Butterfly Mechanics

Let’s say you’ve been watching XYZ Corporation and believe the company’s share price will stay in a range for the next several months. The stock is currently trading for $70.75 a share. Consequently, in the month of May, you decide to create a long iron butterfly by going long one October XYZ 75 call at $2.50 and going short one October XYZ 70 call at $5, which is the bear call spread of the trade. At the same time, you go long one October XYZ 60 put at $1 and go short one October XYZ 65 put at $2—the bull put spread side of the trade. All told, the sale from the short options equals $7 and the cost of the long options is $3.50. 

So, this trade fetches a net credit of $3.50, or $350 per spread. The maximum profit from the long iron butterfly is equal to the credit and will occur if the stock is between the strike prices of the two short options at expiration. If so, all the options expire worthless and the strategist will keep the premium earned from both the bull put spread and the bear call spread. In this example, the maximum profit is $350. Ultimately, the strategist wants the stock to trade sideways. If XYZ makes a dramatic move higher or lower, above or below the breakevens, the long iron butterfly will probably result in a loss. 

To compute the downside breakeven, subtract the net credit from the strike price of the short put, or 61.50: (65 – 3.50 = 61.50). The upside breakeven equals the short call strike price plus the net credit or, in this example, 73.50: (70 + 3.50 = 73.50). A move above or below the breakeven can result in the maximum possible risk, which is equal to the difference between the strike prices minus the net credit. In this case, the maximum risk is $150 per spread: (5 – 3.50) × 100.

Exiting the Position

In the case of the iron butterfly, the strategist wants the underlying stock to remain between the two breakevens at expiration. Moreover, if the stock falls between the two strike prices of the short options, all of the options expire worthless and the trade yields the maximum profit— the net credit.

• XYZ falls below the lower breakeven (61.50): Let the call options expire worthless. Exit the bull put spread in order to avoid assignment.
• XYZ remains between the downside (61.50) and upside (73.50) breakevens: Ideally, the stock price will land between the strike prices of the short options at expiration. Let the options expire worthless and keep the credit.
• XYZ rises above higher breakeven (73.50): Let the put options expire worthless. Exit the bear call spread in order to avoid assignment.


FIGURE  Long Iron Butterfly Risk Graph

Long Iron Butterfly Case Study

A long iron butterfly is a strategy best used when a trader expects sideways movement in a stock or index. A long iron butterfly has the same risk graph as a condor, but is composed of a bull put spread and a bear call spread. This strategy combination creates a net credit instead of a debit. However, the same risks and rewards as a condor are present. Some traders call this a long iron condor, which has the same characteristics. Let’s review: An iron butterfly is a limited risk, limited reward strategy. The initial entry into an iron butterfly creates a net credit, which is the maximum reward. The maximum risk is the difference between strikes less the initial credit. 

For example, if we enter a 30-35-40-45 iron butterfly, we would buy a 30 put, sell a 35 put, sell a 40 call, and buy a 45 call. If our initial credit were $300, our maximum risk would be $200. The maximum profit occurs if the underlying security closes between the two sold strikes at expiration. This is the main attraction of an iron butterfly, as it has a larger maximum profit zone than a regular butterfly. However, the risk also increases with the added reward. As in the previous two case studies, in mid-October 2003, a trader might have looked at IBM and expected it to trade sideways through November’s option expiration on the 21st. 

On October 16, IBM closed at $89.28 and it seemed likely that the stock would consolidate near $90 after a significant decline. As a result, we could have entered an iron butterfly using the 80-85-90-95 put and call options. Since a long iron butterfly benefits from time erosion and we don’t want to give the stock too much time to move out of its range, it’s normally best to use front month options. The November 80 puts could be purchased for $0.35, with the 85 puts selling for $0.95. The 90 calls could be sold for $2, with the 95 calls costing $0.60 creating a net credit of $200 per contract: (.95 + 2.00) – (.35 + .60) × 100. Thus, a total of five contracts bring in a net credit of $1,000, which is also the maximum reward. 

The maximum risk is calculated by subtracting the net credit ($200) from the difference in strikes (95 – 90 = 5). This creates a maximum risk of $300: (5 – 2) × 100 = $300. If IBM were to close anywhere between $85 and $90 on expiration, the maximum profit of $200 per contract, or $1,000 (for five contracts), could be kept. The breakeven points were at $83 and $92 and are found by taking the net credit of $2 and subtracting it from the lower sold strike for the lower breakeven. The upper breakeven is found by adding the $2 credit to the higher sold option strike. Notice how the risk graph shows limited reward and limited risk. 


FIGURE  Risk Graph of Long Iron Butterfly on IBM 

The risk graph also points out that the maximum profit is impossible to achieve until expiration. This strategy rarely sees a trader get out with a profit at the beginning of the trade. This is because an iron butterfly benefits from time erosion. We aren’t going to see as high a reward-to-risk ratio trading an iron butterfly, but our maximum profit is more likely to be achieved because of the wider maximum profit range. IBM shares did indeed trade sideways through November expiration, closing at $88.63 on November 21. This left this trade with the maximum profit of $1,000. If the stock had closed above 95 or below 80, the maximum loss would have occurred.

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