By: Steve Smith
Most people think of and use options to as a tool for directional trading. You buy a call if you think a stock is going up, or you buy a put if you think a stock is going down. Today’s investing advice will take a more complex approach.
For the directional trade to work, you must not only be correct about the direction of the stock, but also about the price level it will get to, which will determine the strike price you need to choose and the time frame it will achieve the target. You also have to be aware of the option’s implied volatility, the great variable which heavily influences the option’s value and which can impact the trade’s probability of realizing a profit.
That is quite a few decisions to make before placing a directional risk trade. Of course, the more decisions you have to make, the easier it is to make an error. The more decisions you can take out of the equation, the better your odds of a profitable trade.
Non Directional Trades
It is also a well-known adage that 80% of all directional options trades expire worthless. That means the person that sold the option and collected the premium is the winner 80% of the time. If you knew nothing else, wouldn’t you want to be on the team that wins 80% of the regardless of how the game plays out? That is, you win whether the stock moves up or down, as long as it stays within a reasonable range. Today’s investing advice will focus on trades like this, where you act as the House, as it were.
This is called non-directional trading, and it lets you profit from option premium decay over time. The main strategy employed is called an iron condor, and involves the simultaneous selling of both a put spread and a call spread for a net credit. The profit is limited to the amount of premium collected and the potential loss is limited to the width between strikes. We look at the details of a specific trade below.
First, let’s go through some start with the advantages of this strategy and how you go about structuring the trade so you have a high probability of success.
Finding a New Post Earnings Range
Some of the best times for using these non-directional iron condors is after a company reports earnings. The stock may initially respond with a large move, only to reverse course. Eventually the stock begins to carve out a new range
Let’s walk the process of setting an iron condor in Cummins (CMI) For starters, the company recently reported earnings on October 31 that initially caused shares drop some 7% to $172. But the very next day shares jumped back to a new high above $180… only to swing lower again and make new lows in the following days.
Now the chart suggests there is good support at the $165 and significant resistance at $172.
Wee can use these levels to set up an out-of-the-money iron condor.
-Buy to Open December 160 Put
-Sell to Open December 165 Put
-Sell to Open December 175 Call
-Buy to Open December 180 call
For a $1.35 net credit
Here a sample Order Ticket
And this is what the order and risk graph looks like.
As you can see, so long as shares of CMI stay between $160 and $175, a near 10% range, for the next month you keep the $135 per contract premium collected.
On a risk of $$3.65, that’s a 36% return in less than a month’s time. Not bad for just watching stock for a few weeks.
As earnings reports fade and we head into the quiet end of the year period, our investing advice is to look for stocks that are settling into a range for using an iron condor. That way, you can still generate income in a range bound market.