This Sector Is Set for a Big Move
Sometimes, as traders, we know a particular stock is set for a big move. It could be related to an earnings announcement. We know the stock will react to the news. We expect a big move. But, we don’t know which way the stock will move.
The same can be true for a group of stocks in a sector. We can see from the news that a sector is set to move. It could be because of an upcoming event like an OPEC meeting for the energy sector. Or, it could be the retail sector as we head into the holiday season.
Retail stocks have had a tough year. The fact is that traditional retailers with brick and mortar stores have had a tough year. They have closed a record number of stores, exceeding the high set in the deep recession that occurred in 2008.
The sector’s weakness can be seen in the price of SPDR S&P Retail ETF (NYSE: XRT), an ETF that tracks the sector. An ETF, or an exchange traded fund, owns a number of stocks in a sector or an index, diversifying the risk. The performance of XRT is shown in the next chart.
After a strong bull market, XRT peaked in 2015 and has been drifting lower since then. The ETF has made a few big moves over the past two years. It is likely the ETF is set to make another big move.
An Options Strategy To Benefit From a Breakout
It is reasonable to expect a relatively large move in the retail sector. This is true because it is near the end of the year and the retail sector tends to report the bulk of its sales at this time of the year. Analysts will be watching the amount of foot traffic at malls and counting cars in parking lots to try to determine if shoppers will deliver a strong quarter for retailers.
The stocks of companies in the sector could rally if analysts see a trend towards shopping at physical stores in the upcoming holiday season. The stocks could also make a big move to the downside if the analysts see signs of weakness in their data.
This situation summarizes one of the problems associated with trading. It can be easier to forecast the fact that a move is likely in a stock than it can be to predict the direction of the move. Fortunately, there are strategies that can benefit from a move, even if the direction of the move can not be forecast.
Traders familiar with options may know the long iron butterfly strategy could help with this situation.
To profit from a large move, traders can use an iron butterfly strategy. The risks and potential rewards of this strategy are shown in the diagram below. The strategy profits from a large move in the stock but doesn’t require the trader to choose a direction for the move.
Source: The Options Industry Council
This strategy combines four options contracts. The trader will buy a call option and a put option with an exercise price that is close to the current price of the stock. The trader will then sell a call with an exercise price above the current price of the stock and also sell a put option with an exercise price below the current price of the stock.
All of the options contracts will have the same expiration date. The options that are sold will have exercise prices that are an equal distance from the exercise price of the options that are bought. Those are the only requirements of the trade. Now, let’s see how the trade works in practice.
Opening an Iron Butterfly in the Retail Sector
For SPDR S&P Retail ETF, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, January 18. This date was selected to allow for news about shopping patterns through the end of the year. Using December options would miss news that unfolds in the last few weeks of 2017.
Selling the options will generate $6.65 in income ($3.15 from the call and $3.45 from the put). Buying the options will cost $7.30 ($3.20 for the call and $4.10 for the put). This means opening the trade will result in a debit of $0.65, or $65 for each contract since each contract covers 100 shares.
That is the maximum risk on the trade. This is generally true whenever an options strategy results in a debit, or the outflow of trading capital when opening a trade. For these strategies, the risk will generally be capped at the amount of capital used to open the trade.
Most brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $65 in capital.
The maximum potential gain on the trade is equal to the following formula:
For this trade in XRT, the option with the highest exercise price is the $41 call. The middle exercise price is the $40 call and put. The difference between these two prices is equal to $1. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium paid to open the trade.
The premium paid is equal to $65. Subtracting that from $100 we find the maximum potential gain on this trade is equal to $35.
The potential reward on the trade ($35) is 53% of the amount risked, a high potential return on investment for a trade that will be open for about a month. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
Gains and Losses Compared to the ETF
This trade generates a gain if XRT moves about 2.5% in the next month. On average, shares of XRT have moved more than 3.2% a month over the past 12 months. Over the past six months, that average has increased to about 34%.
Given the past history, this trade has a high probability of success.
Now, as an alternative, a trader could buy 2 shares of XRT with the amount of capital committed to this trade. Even if XRT has a large move of 20%, the potential gains for share holders are less than the potential gains from this strategy.
Owning shares also exposes an investor to larger risks. It seems to be unlikely, but shares of XRT could drop significantly. Losses tend to present traders with a different problem. Many want to believe the stock price will come back and they hold their positions.
In the end, they may be proven right and the stock could come back. But, they have committed capital to that stock that could be deployed elsewhere if they were not waiting for the stock to recover from a loss. This can be a mistake for smaller investors who need to take quick gains to compound their wealth.
The iron butterfly is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide a low cost way to access an expected move without needing to forecast the direction of the move.
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.