A Trade for Quiet Periods
Sometimes, stocks just don’t move much. The price action appears to fall into a quiet period when there isn’t any significant news and the stock price has nothing to react to. It’s possible to identify times when a stock is expected to fall into one of these zones.
When a trader finds a stock that is unlikely to make a big move, there are options strategies that can be implemented to benefit from the expected lack of price movement.
This might seem odd to newer traders who are on the lookout for stocks that are likely to make a big move. The truth is stocks don’t move all of the time. Some analysts believe stocks are in big uptrends or significant downtrends just a third of the time. Most of the time, stocks are moving sideways.
For traders who only buy or sell stocks, the periods of quiet price action between major trends can be frustrating. They may know a stock is undervalued but the stock stubbornly remains in a trend, waiting for a catalyst to push it higher. This sideways market action can last for months.
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Traders can simply sell a stock and trade another issue while waiting for the breakout. Or, traders can use options strategies to benefit from the sideways trend. This is possible because options are priced based on a variety of factors, including the price of the underlying stock and volatility.
Because options prices reflect volatility, the lack of volatility in a stock that is in a trading range presents a trading opportunity. This opportunity is present in the option precisely because the stock is in a trading range and provides traders with a chance to profit from the times when a stock isn’t moving.
Identifying a Potential Quiet Period
One indicator that a stock isn’t likely to move can be found in its valuation. The stock might be deeply undervalued based on traditional fundamental indicators. In these stocks, it usually takes an earnings report to provide a catalyst to break the stock out of its quiet period.
The second indicator to look for is the expected date of the next earnings announcement. Traders looking to benefit from a lack of volatility will want to use options that expire before the next earnings announcement.
The final indicator to consider will be technical. Traders will want to confirm that the stock’s volatility is declining by using a technical indicator such as the average true range, or ATR.
The ATR is an average of the true range (TR). The TR measures how far a stock moved on any given day, including the impact of any opening gaps in the calculation. The range measures the distance from the high to the low. This misses the opening gap, if one occurs. The TR includes the gap in its calculation.
By averaging the TR, the ATR provides a quantified measure of the stock’s recent volatility. This indicator decreases when a stock’s volatility declines because the values of the TRs become smaller as the stock settles into a trading range.
When volatility declines, we expect the stock price to remain within a relatively narrow range. One option strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk. We will look at the strategy in detail, after we find a stock that is set up to benefit from this trade.
Micron Looks Like an Ideal Trade
Let’s see how the stock looks based on our three criteria.
Micron Technology, Inc. (Nasdaq: MU) is deeply undervalued according to the price to earnings (P/E) ratio. Analysts expect Micron to report earnings per share of $4.71 this year and $6.05 next year. The stock is trading with a P/E ratio of about 7 based on this year’s expected earnings and 5 based on next year’s expected earnings.
The company is expected to announce earnings in early October. Historically, the company announces in the first week of that month.
The ATR is declining as shown on the chart below. The stock has settled into relatively narrow ranges in the past after the ATR turned down.
Because of its valuation, the downside in Micron should be limited. Several analysts have noted the stock’s appeal at the current price.
Recent upgrades include a note issued by analysts at Stifel Nicolaus who reiterated its “Buy” rating on the stock and a favorable mention from CNBC personality Jim Cramer, who today said MU stock is trading at a “ridiculously low multiple.”
The Trading Strategy
To open an iron condor trade, a trader sells one call while buying another call with a higher exercise price and at the same time sells one put while buying another put with a lower exercise price. There will be a total of four contracts involved in the trade.
Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor
For Micron, the trade can be opened using the following four options contracts:
- Buy MU Sep 15 $34 Call at $0.15
- Sell MU Sep 15 $32 Call at $0.41
- Sell MU Sep 15 $28.50 Put at $0.43
- Buy MU Sep 15 $26.50 Put at $0.13
This trade has about three weeks to expiration.
Notice that all of the options expire on the same day. The difference in the exercise prices of the calls or puts is equal to $2. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $200 less the premium received when the trade was opened.
Selling the options will generate $0.84 in credits ($0.41 from the call and $0.43 from the put). Buying the options will result in a debit in the amount of $0.28 ($0.15 for the call and $0.13 for the put). This means opening the trade will result in a credit of $0.55, or $55 for each contract since each contract covers 100 shares. That is before commissions are considered but commissions should be small at a deep discount broker.
The maximum risk on the trade is $1.45, or $145 since each contract covers 100 shares. This is the difference between the strike prices ($200) and the credit to open the trade ($55). Most brokers will require a margin deposit equal to the amount of risk. That means this trade will require just $145 in capital.
The potential reward on the trade ($55) is 38% of the amount risked, a high potential return on investment. The trade will be open for less than three weeks. If a trade like this is entered every three weeks, a small trader could obviously quickly increase the amount of capital in their trading account.