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 StrangleIn 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.
I'd strongly encourage the use of limit orders on these, in this case using both pieces together rather then legging in when trying to establish a position. If you don't get filled at your price, forget about it.
Straddles Can Leave You Without a PaddleSome folks might be willing to step up and sell some nearer-term options, namely November options that expire this Friday, in order to capture the acceleration of time decay as expiration nears. This likely would involve selling a straddle, which is being short both puts and calls with the same strike price. A straddle increases the position's potential risk disproportionately to the increase in the maximum potential profit. For this reason, I suggest selling a strangle rather than a straddle (the November 1230 straddle can be sold for approximately $7.20 total credit) because at-the-money options retain the most time premium. This means they will be worth something right up until expiration and they carry assignment risk, as it is likely one side will expire in the money. It's better to sell slightly out-of-the-money options, which have a higher theta, on short-dated options -- especially if break-even points or the range in which the position can produce a profit can be expanded. Our strangle position has break-even points of 1202 and 1268 on the S&P (the total premium collected plus the call strike and minus the put strike, respectively), representing a range of 66 points, or 5.3%, at current levels. Through the first 10 months of this year, the S&P has stayed within a 6% range during any four-week period, so we have statistics on our side. But beware, this position does carry substantial risk. All it takes is one terror event or even a false alarm to send stocks reeling -- and you scrambling for cover.
But if the market is able to calm down, consolidate over the next two weeks and still trade between 1220 and 1240 as of Dec. 1, or two weeks from today, you can expect time decay to bring the 1220/1250 strangle's value down from $18 to approximately $10 during those 14 trading days. That's a 44% reduction in value, which translates into a 28% return on investment (standard margin rules applied). If this type of profit is available at that time, I would suggest closing out the position. Trying to carry a naked option position all the way to expiration increases the risk, without a commensurate increase in the potential reward.