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Strangle This Trading Range

The S&P 500 has climbed some 3.5% over the last three weeks, and finally seems ready to break out of its five-month-long trading range.

But just as the decline to 1160 did not set off an extended downtrend or bear market, this recent rally appears likely to stall before reaching new highs and igniting a new bull market. For now, we may be preparing to settle back into a narrow trading range for the next few weeks as market participants catch their breath, reassess the energy and inflation situation, or simply take some time off until after Thanksgiving.

With earnings, the Federal Reserve meeting and Tuesday's official introduction of Ben Bernanke behind us, there appear to be few catalysts to drive the market meaningfully in either direction.

Stocks will probably probe the high end of the range and experience some knee-jerk, though relatively shallow, selloffs as the S&P 500 approaches the old 1245 high. I'd expect the S&P 500 to trade within the bounds of support of 1210 and resistance at 1245, a 2.5% range, for the next two to three weeks.

Sit Tight With a Strangle

In a range-bound environment, some of the most effective strategies involve either selling option premium or establishing positions for a net credit.

The most obvious and straightforward of these plays comes in the form of straddles, in which traders sell an equal number of puts and calls with the same strike price (usually at the money), and strangles, in which traders sell an equal number of puts and calls with different strike prices. Remember, though, that a short straddle or strangle consists of being naked options, meaning the position carries the risk of a theoretically unlimited loss.

But for those bold enough to step into the fray, they offer a neutral position that provides a great way to collect some incremental profits during a relatively flat market. Given my belief that the S&P will remain within a 2.5% range, I would suggest a short strangle, selling the December 1220 puts and the December 1250 calls. A similar strangle can be established in the Spyders (SPY), using the $121 and $125 call.

Someone putting this trade on would simply use a multiple of 10 (for every one SPX contact trade 10 SPY contracts) to achieve a similar position in terms of cost and risk/reward. With the SPX trading at 1230, the December 1220/1250 strangle can be sold for a total net credit of $18 -- approximately $11 for the puts and $7 for the calls.

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