High Volatility Creates Unique Trading Opportunities
Recent market action has been volatile. That can be seen in the price moves of any of the major market averages. They all show an unusual pattern.
Heading into the end of January, major market averages were reaching new all time highs. That is a bullish indicator since new highs more often than not tend to be followed by additional new highs. These new highs were instead followed by a rapid decline of more than 10%.
The chart above shows the SPDR S&P 500 ETF (NYSE: SPY), an ETF that tracks the S&P 500 index. It shows the new highs, a correction of more than 10% in less than two weeks and then a quick recovery retracing nearly two thirds of the decline before it stalled.
This is an unusual level of volatility in a short amount of time and the volatility is visible in the charts of many individual stocks as well as the indexes. In some cases, individual stocks have experienced more volatility than the indexes.
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Target Corporation (NYSE: TGT) is an example of a stock with greater than average volatility as the next chart shows.
The downside gap that occurred when a competitor (Walmart) reported earnings further increased volatility which is an important factor in options prices. Recent price action has elevated options prices and in the case of Target, there is an additional factor contributing to high options prices.
Target will announce its earnings near the end of February. The stock has a tendency to make a relatively large price move after its quarterly earnings announcement. Traders tend to price this into options, elevating premiums ahead of the announcement.
This presents a possible trading opportunity. Knowing premiums are elevated, strategies that sell options could be attractive. However, there is no way to forecast the directional bias of the expected price move. This means a trader might not know whether it is best to use a strategy that involves selling puts of calls.
There are options strategies designed to benefit from volatility even if the trader is unwilling to take a position on the direction of the volatility.
A Strategy to Benefit While Waiting for More Details
As we wait for more details on the company’s performance, we could see stocks settle into a trading range. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. 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 in Target
For Target, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, March 16.
The difference in the exercise prices of the calls or puts is equal to $4.00. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $400 less the premium received when the trade was opened.
Selling the options will generate $2.40 in income ($1.45 from the call and $0.95 from the put). Buying the options will cost $1.05 ($0.60 for the call and $0.45 for the put). This means opening the trade will result in a credit of $1.35, or $135 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($4.00) minus the premium received ($2.40). This is equal to $1.60, or $160 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $160 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $2.40 or $240 per contract.
The potential reward on the trade ($240) is about 150% of the amount risked, a high potential return on investment for a trade that will be open for about one month. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
This trade could also be closed out early to reduce the potential risks of the trade. It could still deliver its maximum gain even if the position is closed before the expiration date of the options.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.