Learning to Appreciate Range-Bound Markets - Option Ideas

Long-term credit spread traders have another reason to cheer! For the past five years the Standard & Poor's 500 has produced an average annual rate of return of -1%, and most forecasts for the next five years aren't much better. Are we in for more of the same? I would certainly hope so!

Range-bound markets provide fertile hunting grounds for diagonal spread traders. If the term "diagonal spread" causes you to run for the doors in a state of panic and confusion, rest assured, it is a very simple yet effective option strategy for almost anyone. I once heard someone refer to a diagonal spread as, "a poor man's covered call". I'm not sure if I agree with that description; nevertheless the point is clear, it is an inexpensive way to trade covered calls.

In a covered call trade, the investor owns the underlying stock and sells a call option on the stock. The investor believes the stock will move up or sideways during the option period. If the stock price stays below the strike price plus the call premium (i.e., the break even point), the covered call strategy outperforms holding the stock. An ideal trade for a range-bound market.

Covered Call Example

Buy 100 shares of IBM at $125
Sell 1 Oct 130 Call at $2.60

Break Even: $125 – $2.60 = $122.40 pr/share or $12,240

Let's assume the stock, IBM (IBM), moved sideways over the next 30 days, and the investor kept the entire $260. The investor outperformed the stock and earned a static rate of return of 2%. Not a bad return for a sideways trending stock.

What if an investor cannot afford an investment of $12,240, what's he/she to do?

Rather than buying IBM for $125 per share, the investor can purchase the January 115 call option. An in-the-money option contract with four months of duration is a lot less expensive than buying the stock. And more importantly, the shorter term contract should depreciate at a higher rate than the longer term contract. Once again, a profitable trade in a range-bound market.

Diagonal Option Example

Buy 1 IBM January 115 Call at $16.75
Sell 1 IBM October 130 Call at $2.60

Net Cost: $16.75 – $2.60 = $14.15 or $1,415

Break Even: 115 strike + $14.15 = $129.15

For ease of explanation, let's assume the stock moves sideways over the next 30 days and the implied volatility, dividend yield, and interest rate were unchanged. The value on expiration Friday in October should be as follows:

Buy 1 IBM January 115 Call at $16.20
Sell 1 IBM October 130 Call at $0.00

A static return of 14% should be appealing to even the most disinterested market players.

Now, before you run out and trade your first diagonal spread, it is a good idea to spend time learning the potential risk from a drop in the stock price.

You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

And be sure to check out our new Zacks Options Trader.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

 
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