Market direction will be an unknown entity this weekend as the country of Greece looks to vote once again for a government. The mood of the market could be euphoric or downright dismal depending on who wins this election in Greece. Trading Options for this type of event can sometimes turn out to be a very profitable exercise.
Gambling On Market Direction
When I was younger and had a much smaller portfolio, I had to take higher risks than I do today. There were many events over the past 35 years of investing that ended up being highly profitable and I used strangles and straddles for almost all of them.
2008 Market Direction Strangle
The best by far was on September 9 2008 when I put in place a strangle on the S&P 500 through the SPY when the Federal Reserve had announced several times that the Housing Crisis was well contained. The market direction was already down when back on September 3 2008 the MACD Histogram went negative despite the constant chatter from the Fed. I have always found that if the Fed acts then it is time to invest, but if the Fed just talks, then there are usually problems investors are not aware of.
On that day the S&P 500 was at 1267.79. By Oct 6 the S&P was down to 1010.00 when I closed out my positions. I sold on October 6 because Jim Cramer was on MSNBC that day talking about how investors should remove from the market everything they would need for the next 5 years. I figured that might mark the end of the selling. Afterall the market was down huge from the high in 2007. I had already made an incredible profit so I closed my position and got ready to sell puts. It was a mistake since the market moved a lot lower in the preceding months.
To help pay for the cost of the strangle options trade I sold spy calls on Sep 25 turning part of the trade into a spread.
Market Direction SPDR 500 ETF Strangle VS Straddle
My choice for the upcoming weekend would be the SPDR 500 ETF Strangle. A straddle might be more profitable but the cost is more as well. Instead I prefer the strangle because it is cheaper and easier to defray some of the cost.
To understand the Strangle I need to look at the S&P 500 chart for the past 6 months and compare it to the SPY (SPDR 500 ETF) chart for the same period.
What I am looking for are strike positions that have the best chance of profit through wide swings in market direction. In trading options, a strangle means buying puts and calls at different prices for the same month. A straddle would be a more expensive way of trading options since a straddle is buying put options and call options at the same strike for the same month. The strike I would pick for a straddle would be the SPY $133 strike. The July 21 $133 call options are trading at $3.51 and the July 21 $133 put options are trading for $3.32. The cost to put in place a straddle would be $6.83 or $13660 for 20 contracts of each.
S&P 500 Compared To SPDR 500 ETF (SPY)
For this trade I look back 6 months on both the S&P 500 and the SPY or SPDR 500 ETF. On the S&P 500 the low of this correction has been 1266. The next level of resistance in this correction is at 1357.
Comparing those levels against the SPY, shows me that the low is 128 and the resistance at 136. Therefore if the election goes against austerity and for leaving the Euro, the market could fall to $128 before falling further. The same is true for the upside. The next level of resistance is at 136. Therefore I will put my strangle into play by purchasing the 21 JULY 2012 $136 calls and the $128 puts.
The July 21 $136 call could be purchased for $1.87 and the July 21 $128 put for $1.82. Instead of buying the $128 put I would buy the $129 which is trading for $2.07. The cost difference is small and this could result in significant profits if the market direction swings far enough either up or down. By buying into July options, I am giving myself enough time for the trade to work out should the market direction not swing very far.
The cost for the strangle is only $4140.00 for 20 put options contracts and $3740.00 for 20 call options contracts for a total cost of $7880.00.
If the market on Monday takes off or falls apart I will profit handsomely. If the stock market direction stays the same I can close for small losses as long as I do not wait until July.
The overall cost for the strangle is half of the cost of the straddle and if the market direction moves wide enough on Monday I could receive significant gains with limited losses on either the puts or calls options depending on which way the market direction swings.
Turn The Strangle Into Option Spreads
The cost for the strangle while just half of the straddle could be reduced a lot further by looking at the charts again and picking SPY PUT and CALL strikes to sell for income. To do this I want to pick strikes that are far enough out of the money that the chance of them ending up in the money are slim.
To figure out which out of the money strikes to pick, an investor must balance the option premiums being received against the likelihood of the S&P 500 reaching those strikes. To do this I bring up the same charts and have a look. The most recent lower higher on the S&P was 1405 and the high for the year was just above 1420. The S&P 500 lows are back in early January at 1250 and in December 2011 at 1212.
These levels correspond with the SPY levels of 142 and 140 on the upside and 124 and 122 on the downside. I then look at the option premiums I can earn by selling these SPY Options contracts. All of the strikes in blue, being considered would still allow me to profit from the market direction swing either up or down.
Selling SPY PUT and SPY CALL Options
Since this is a short-term trade which could easily be just one day, all the option strikes under consideration are reasonable for earnings potential. Because this is a short-term trade I would sell the SPY Options for the same month, July.
The July 124 puts can be sold for $1.10 and are far enough out of the money that should the market fall, it would take a major plunge to reach 124 overnight.
The SPY CALL 140 can be sold for .54 cents.
Trading Options Against Market Direction Calculation
Selling the above calls and puts would result in income earned of 20 spy call contracts X .54 = $1080.00
20 spy put contracts would result in income of $2200.00.
My strangle options trading cost would be reduced by 27% to $5680.00.
Trading Options Summary
This is an easy to implement option trade with a total cost of $5680.00. It has a good chance for profit potential and has a long enough time period to give the options trade enough time to turn profitable should the market remain neutral.
A neutral market direction in the present stock market seems highly unlikely so this simple trading options strategy could be an excellent means to hedge against a serious market panic or euphoria on Monday after the Greek Vote.