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By: Chris Rowe — October 29, 2013

Technical Tuesday: Profit If S&P is Within a 4.6% Range

The intermediate-term trend shows demand in control, BUT the market is relatively overbought.  What should you do?

If you believe the market is likely to end up at about the same place in a month or so, then you should be "selling time". 

Huh?

If the market stays at the same place, the only thing that we have less of is TIME.  How can we sell-short TIME?  I'll get to that in a minute.  But let's take a look at the S&P 500 for a sec...

Compare the price chart of the S&P 500 for this year to the highly reliable momentum indicator, the "RSI".  You can see that when the RSI gets up to the levels we are currently seeing (blue horizontal line), the market usually has either:

  • Traded up a bit but then revisited the same level it had been at when the RSI first reached this level...
     
  • Traded sideways for quite a while...
     
  • Or topped out, only to revisit the same level it had been at when the RSI first reached this level.

Below I have listed the dates that the RSI reached the level it's at currently (68.20), followed by the dates the S&P 500 can be found at the same levels.  In other words, we are considering what would have happened if we "sold time" on the first listed date and then exited the position (bought back the spread) on the following date/s.  On the following dates is when the S&P 500 was at the same exact level. 

Example:

Date Current Level Was Hit -- Date that price point was seen again

1/17 -- 2/26
2/19 -- 3/5
3/11 -- 4/4 - 4/22 (market traded flat most of this time)
5/8 -- 5/31 -- 6/3 -- 6/6 -- 6/12 -- 7/5
7/15 -- 8/14 (market traded flat most of this time)
9/17 -- 10/17

You can see that, once the price levels were hit, they were seen again within about 4-6 weeks. 

So how do we sell time?

There are many ways to do this using options contracts.  Options contracts have a time component that options BUYERS are well aware of. 

When you own an option contract you quickly realize that, as time passes, the option can lose value.  This is called "time decay".  If your underlying stock or ETF is moving in the right direction, much of that "time decay" is offset and you end up profitable.  But if your stock or ETF trades FLAT (sideways) you would likely see the option contract lose some value. 

Most stocks and ETFs have lots of options contracts to chose from -- oftentimes, hundreds of different options contracts to chose from.  Each one behaves differently, depending on their strike price and expiration month.  Some option contracts experience lots of time decay and some don't experience time decay at all. 

As an OWNER of an option, you want the option to advance in price.  You want to choose an option that experiences little time decay.

But if you are a SELLER of an option (you are selling-short an option) you want to do so with an option that experiences lots of time decay.  Why?  In this case, time decay works in your favor.  Remember, we are selling-short TIME. 

Thus, as time passes and the option loses value, you are making money.  You want the option to lose value since you have sold the option short.

If we think the only thing that will change is time passing, then we want to short time.  In this case, you are collecting income.  And the vast majority of the time, stocks trade sideways.

There are many ways to sell time.  Some strategies have lower risk and lower reward, while others have higher risk with higher reward.  That's the beauty of options trading.  You can structure the trade with the exact amount of risk and reward that you're willing to incur. 

The strategy I'll cover today is called the "Strangle".  A strangle involves a call option that is slightly out of the money and a put option that is slightly out of the money.  (Stay with me here, you'll catch on if you don't already "get it".)

You can either buy both options (long strangle) or sell-short both options (short strangle).  Since we are selling time, we are going to hypothetically sell both options.

The ideal options to sell for this strategy expire within 6-8 weeks.  So let's focus on the options that expire on December 20th.  And in case you don't already know, you can enter or exit this position any time you want to.  You do not have to wait until expiration day to do anything.  In fact, I recommend traders exit this before the expiration day of December 20th. 

Let's look at the ETF that tracks the S&P 500 (Symbol SPY).  The idea is to sell slightly out of the money puts and slightly out of the money calls. 


What does that mean? 

You want to sell-short the call options with a strike price slightly above the price at which SPY is currently trading, and sell the put options with a strike price slightly below the price at which SPY is trading.

Considering the SPY closed at 177.22, it means you want to simultaneously:

Sell the SPY 180 calls (to open)

and

* Sell the SPY 174 puts (to open)

Again, we will focus on the options that expire December 20th. 

I would do this no matter where the market opens tomorrow.  But today the two options closed with a combined value of $4.12.  In a perfect world, you would see SPY trading somewhere between the two strike prices of 180 and 174 a few days before expiration and keep almost the entire $4.12. 

Keep in mind, that amounts to 2.3% of the current value of the SPY (2.3% of the value of the S&P 500) in just 52 days.  That's an annualized return of 16.3%, which may not seem huge in comparison to the market's recent performance.  But once you consider the risk, it becomes much more appealing.  You are simply betting that the market will be trading within a 4.6% range from where it is today (2.3% higher or 2.3% lower). 

If the market is within 2.3% of today's closing price (up or down) on December 20th, you've collected 100% of that $4.12. 

What's the downside?

Because we are talking about options contracts, and because there are a few variables contributing to how the market prices the options, we will keep it simple and speak to the situation we would find ourselves in on expiration day. 

On expiration day, your break-even would be each of the strike prices + that $4.12 you collected for doing the trade. 

Since the call option's strike price is 180, your break-even at expiration is with SPY at $184.12.

Since the put option's strike price is 174, your break-even at expiration is with SPY at $169.88.

Basically, you want the S&P 500 to stay within the range seen highlighted in purple, below.

So if SPY is above 184.12 or below 169.88, at expiration day, you are losing money.

How much are we losing?

It all depends on what you put behind the idea.  There are two different option contracts you can chose from (and if this is starting to sound complicated at first glance, just know that if you follow the steps, it's WAY simpler than it seems at first read.  The fact that there are two different options contracts to chose from actually makes things easier for you.) 

There are the "traditional options contracts" which represent 100 shares of stock.  But recently, they introduced "minis" which represent 10 shares of stock. 

For example, if you were to sell one call and one put (so you would be selling one strangle), using the traditional options, then it's like trading 100 shares of a 177.17 stock.  Therefore it's like trading a $17,717.00 position.  If that's the type of position size you're comfortable with (owning the S&P 500) then that's perfect for you.

If you did the same with 10 calls and 10 puts (10 strangles) then you're controlling $177,170.00.

The minis offer some more flexibility.  Since minis control 10 shares of stock and traditional options control 100 shares, trading 10 minis would be the same thing as trading 1 traditional.  But if you want to control $26,575 worth of SPY, then you would be well suited to trade 15 minis (since you can't trade 1.5 traditional option contracts). 

The downside risk, at expiration (December 20th) if you traded 1 strangle using traditional options would be $100.00 for every point the SPY traded above 184.12 or below 169.88.

It would be like losing $100.00 on a $17,717.00 position per point above $184.12 or below $169.88.

If the S&P 500 moves a whopping 5% from today's closing price, it would be like losing 3.7% on your position.  I hope you get the picture.  Just remember that you can close the position out at any time.

The best way to learn, in my opinion, is to just try it.  This is an excellent strategy to learn so you can use it in the future when you feel the stock market won't be doing much at all, or will zig-zag and end up in the same place. 

What's the worst that can happen?  Well, you'll have to structure your account so that your risk is minimized.  You can always sell to limit losses.  Or you can always take a very small position just to see how it works. 

The SPY's price is almost like moving the decimal point over on the price of the S&P 500. 

The S&P 500 is currently at 1,771.95
The SPY is currently at 177.17

It has a quick decline each quarter due to a dividend payout.  It's a non-event to this conversation. 

Just to translate the break-even points at expiration to the actual S&P 500, we want the S&P to be between 1,812.70 and 1,730.90.

I know 2.3% may not sound very enticing, but remember you're simply betting that the S&P 500 ends up within a 4.6% range over the next 6-7 weeks.  I hope you'll benefit from adding this strategy to your arsenal.  See you next Tuesday.

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