Trading breakouts with options

08/31/21
  • DIS in three-month consolidation since late May
  • Candidate for “non-directional” options strategies?
  • Time horizon, volatility expectations key to minimizing drawbacks

Although trends and trading ranges can last longer than many people think, they can’t last forever. So when a formerly trending market has been stuck in a rut, you can bet some traders will be thinking about non-directional options strategies designed to profit no matter which way prices go.

The critical element of the preceding sentence is “designed to,” as a simple example will help illustrate.

Disney (DIS) has been trading sideways for the better part of three months since pulling back from its early March record high around $203, failing to break out even after a big earnings beat earlier this month:

Chart 1: Disney (DIS), 9/15/21–8/30/21. Disney (DIS) price chart. The range after the rally.

Source: Power E*TRADE (For illustrative purposes. Not a recommendation.)


While any stock’s retreat and consolidation after a big rally would strike many traders as a logical cool-down phase, in this case there are probably traders on both sides of the aisle who would argue that DIS is poised to push out of its current range—for example, bulls who think the delta variant is unlikely to trigger the type of lockdowns that disrupted business last year, and bears who think the lingering uncertainty may be enough to push some investors toward the exits. Throw in the fact that we’re heading into the historically most volatile stretch of the calendar, and there’s a case to be made for a breakout—up or down.

Knowing when such a move will happen and how big it might be is a different story, of course. But traders who expect a dormant stock’s volatility to kick into gear—while remaining neutral about its direction—sometimes consider options strategies like the long strangle, which combines a long out-of-the-money (above the current stock price) call with a long out-of-the-money (below the current stock price) put with the same expiration:

Chart 2: Long strangle risk-reward profile. Unlimited potential profit, but that profit can be elusive.

Source: Power E*TRADE (For illustrative purposes. Not a recommendation.)


The advantage of the strategy: It can profit if the stock goes up or down, since one of the options will always be “right.” The catch: It has to move enough to make up for the combined cost of the two options, which is often no small feat. Monday morning, for example, a trader who was thinking about putting on a strangle consisting of a long DIS October $190 call and a long DIS October $170 put  would have had to shell out $455, which means the stock would have to rally at least $4.55 above $190 or below $170 for the strategy to begin making a profit.

Some traders try to lower this hurdle to profitability by selling two additional options: a higher-strike call and a lower-strike put. The modified position is often called an “iron condor,” which as the following chart shows, has the disadvantage of having limited profitability (notice the flattened “wings”). But it has the advantage of costing less than the strangle (since the trader collects premium on two short options), which means the stock doesn’t have to move as far to produce a profit:

Chart 3: Long iron condor risk-reward profile. Lower price tag, but profits are limited.

Source (data): Power E*TRADE. (For illustrative purposes. Not a recommendation.)


In the case of DIS, adding a short October $200 call and a short October $160 put to the long strangle to create a long iron condor reduced the cost of the position from $455 to $285—a 37% improvement for giving up any additional profits in the event the stock kept rallying above $200 or kept falling below $160.

One strategy isn’t necessarily better than the other—it’s a question of how much a trader thinks a stock will move, and when it’s likely to do it. But one risk both approaches share is that the stock will continue to move sideways—that is, volatility will remain low—in which case both long options would expire worthless.

In the markets you can never eliminate risk, you can only manage it.

 

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