By Josip Causic, Online Trading Academy Options Instructor
Why would anyone want to trade options when they are risky to trade? My simple answer to this or similar types of questions is: Option trading could be profitable even if the market goes sideways, while directional equity trading isn't profitable during directionless times. There is no time when this could be more accurate than in the current market situation. In my option articles, I often focus solely on option strategies and seldom discuss my outlook of the market in terms of its direction. In this newsletter, I will make a one time exception to that decree. Again, the following market outlook described in this newsletter is my opinion and it should be taken with healthy skepticism. At no time should it be taken as advice to be traded.
Any trader using the moving averages knows the significance of the 200 period moving average. The big institutions use it, along with broker-dealers, fund managers, as well as us, small retail traders. We all find it to be useful. Now let us briefly look where the broad market currently is in relationship to its respective 200 moving averages. Figure 1 below shows the four daily charts of the four broad markets. From left to right, and top to bottom they are: S&P 500, Dow, NASDAQ, and Russell 2000. The blue line on each daily chart is the 200 simple moving average.
Figure 1 As of the writing of this article, the Standard and Poors 500, the Dow Jones Industrial, and the Russell 2000 are just below their 200 moving averages; whereas the NASDAQ, the strongest of the four major markets, is slightly above it. Now having said that, let me remind the readers that the 200 period moving average usually acts as a magnet for the price action, and the fact that all three major US indices are hugging their respective 200 moving averages means, in my opinion, that the market during the summer might be range-bound.
In other words, I think that the market might go a bit down, and a bit up but overall, it might just end up going sideways. In such case, being an option trader, what strategy should be used? Hint: an I.C. (Iron Condor). Those committed Online Trading Academy readers have already been exposed to this directionless strategy through my previous articles. I have listed them in chronological order and suggest the readers unfamiliar with them refresh their memory by re-reading them. They were (1) I.C. Explained, (2) Iron Condors Versus Condor Spreads, and (3) Iron Condor Revisited.
Basically the trading of Iron Condors involves the simultaneous handling of OTM, out of the money, options for buying and selling, ending up with a credit. The most essential part to keep in mind is that the transaction I am referring to needs to be the shorting of an Iron Condor. I have seen some traders unconsciously make the huge mistake of actually purchasing them instead. The intention of a Condor-ian (an Option trader who trades Iron Condors) is to be a net premium seller, keeping in mind well-defined levels of support and resistance. Based off those two levels, the sold strike prices are being picked for the call and the put side, giving enough room for price fluctuation. Below is the template that I use when trading condors. It has two sides.
Bear Call side
BTO + 1 Higher Call Strike that is deeper OTM
STO – 1 Lower Call Strike that is deep OTM
Bear Call Max Profit is the difference of the two premiums
Bull Put side
STO – 1 Lower Put Strike price that is deep OTM
BTO + 1 Higher Put Strike price that is deeper OTM
Bull Put Max Profit is the difference of the two premiums
Combined Max Profit involves addition of both maximum profits from the bull and bear side.
Max Risk = strike spread width minus the combined Max Profit
As an additional note, I have seen students who were too eager to place the Iron Condor make the following two mistakes: (1) buy an Iron Condor when they intended to sell it, and (2) create different strike widths for the bear side or for the bull side. The second mistake is not as detrimental as the first one, yet the point remains that the broker will hold the requirement based on the larger width spread. For instance, if the Bear Call side has a 10 point spread between the strike prices but the Bull Put has only a 5 point spread, the broker will always keep the requirement of the greater spread. Making such a negligent mistake, as placing the "off-balance" Iron Condor, causes the whole mathematical calculation of return on investment for an Iron Condor to change for the worse. Hence, be on the lookout for those two key points.
In conclusion, in this article I have provided the readers with insight into my personal impression of the stock market direction during this summer; completely directionless. No equity trader could claim to have a profitable solution to a sideways market and it is a well-known fact that the markets tend to go in three directions: up, down, and sideways. Option traders, on the other hand, do have a strategy in their arsenal which could be used in the sideways market. The choices are there for those with specialized knowledge. Good Trading.
- Josip Causic
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