How to Profit from Options During Trading Ranges

12/15/2009 12:01 am EST

Focus: OPTIONS

The market has been in a trading range for over a month now.  If you take a look at the S&P 500 Index (SPY) (SPX), it has been locked into a range of between 108 and 112 since early-November, with 110 being a key mid-level (and an important round psychological level) equivalent to 1,100 on the SPX.  Examine the following chart and you will see the clear trading range, however, we have been in somewhat of an upward-sloping trend (red lines) and closed last week in a strong fashion. These trend lines give a near-term upside target of 113 should we break out to the upside. Percent R on the daily chart is also holding strongly and is back above the 80 bullish level.

So how does one benefit from this trading range, whether you think 108 to 112 will hold through December expiration, or even if you think we will break out to 113?  Iron condors are a good method to do so. I often prefer to utilize the SPY for such strategies due to its incredibly high volume/liquidity, low bid/ask spreads, and one-point strike increments. Iron condors can be placed to bank on a range holding and are basically a combination of selling a call spread and selling a put spread for one overall trade.

SPY Daily Chart

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There are various iron condor strategies that can be used to collect time decay in the last one to two weeks before expiration. We trade strategies like credit spreads, debit spreads, and iron condors in BigTrends’ advanced option strategies program. We will look at three similar—yet different—strategies next.

MORE: Lesson Continues on Page 2

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First, there is the 110/109 + 112/113 iron condor on the SPY. You can see the profit/loss graph on this position from OptionVue based on last week's closing prices. This is banking on the 110 to 112 range holding, and is fairly aggressive. This is basically neutral around the 111 level. You can see that you receive a good premium for selling this condor, receiving 0.57 on a net risk of 0.43 gives a potential net profit of 132% (not including commissions) on risk, based on a 110 to 112 Friday SPY close.

The reason why the net risk is 0.43 is that we are selling one-point spreads in all of these strategies—one call and one put. Only one of these spreads could end up going to the maximum value of 1, so the maximum risk in these examples is 1 minus the premium/credit received.

SPY Iron Condor

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Here is a wider-range trade, also based on keying on the 111 level as the middle neutral level. In the following example, we extend up to the 113 strike on the upside and down to 109 on the downside. You could also extend down to 108 on the downside to give even more protection cushion (banking on a 108 to 113 range holding), but your net gain will be even less. In this example, we would receive around $33 per condor placed, giving about a 49% maximum gain on risk.

SPY Iron Condor

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Still another way to play this trading range would be to go to the original range of 108 to 112.  That has held for over a month now, so why not one more week?  In this 108/107 & 112/113 iron condor below, you can see that based on last week's closing prices, it has a bearish/neutral bias. There isn't much cushion to the upside breakeven level of 112.41.  This trade does give a potential maximum profit of 69% on risk, again not including commissions.

SPY Iron Condor

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So you can see that there are a variety of methods to profit from a trading range, especially as expiration approaches and time decay kicks in. Which method of these would I prefer? Well, we have to see how the market opens this week, but I would be inclined to protect up to 113 on the upside. The middle of the three trades, the 109/108 and 113/114 iron condor at around a 49% profit on risk, if I had to choose one of these right now (that's in one week, annualize that for a year, or even multiply 12 times, once per month, and you will be amazed at the annual numbers).

By Moby Waller of BigTrends.com

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