Setting trading boundaries
07/10/18

Many people think of trading in binary terms: If you’re bullish, you want the market you’re trading to go up, and if you’re bearish, you want it to go down.

True enough, but options traders can add some other dimensions to their trades—or, looking at it from another perspective, they can remove certain dimensions—namely, the whole “price up-down” thing.

For example, a stock that’s moving sideways (and is expected to do so for the foreseeable future) is unlikely to garner much attention from bullish or bearish traders. Options traders, on the other hand, may see an opportunity.

Take a look at the following chart high-flying networking company Arista Networks (ANET). For the past several months the stock been trading in a broad range, roughly between $235 and $312 (its all-time high from earlier in the year). Some traders may look at the chart and see a stock that’s going to break out of its range; others will see one that’s more likely to continue to trade as it has for the past several months.

Arista Networks (ANET), 8/25/17 – 7/10/18. Arista Networks (ANET) price chart. Which way next?

Source: OptionsHouse

Let’s say a trader (even one who thought the stock would eventually push higher) felt the stock would probably remain within the range for the next few weeks. An options trader could take advantage of this situation by shorting both out-of-the-money call options (strike price above the current stock price) and out-of-the-money put options (strike price below the current stock price). As long as the stock continued to trade between the two strike prices, the options would eventually expire worthless, and the trader would get to keep the collected premium.

While options buyers want to trade relatively underpriced options, options sellers are always on the lookout for potentially overpriced options. In this case, there was one indication ANET options may be relatively overpriced, at least in the short term: They showed up yesterday on a LiveAction scan of the biggest one-week implied volatility increases:

LiveAction scan: Large one-week gain in IV. Implied volatility increase

Source: OptionsHouse

Implied volatility (IV) is the market’s estimate of future volatility that is represented in an option’s price; the higher the IV, the higher the price. The LiveAction scan shows ANET options had a 35.51% IV increase from the previous week.

So, what strike prices and expirations would an options trader select to take advantage of the situation? A reasonable (conservative) choice would be to sell a call option above the high of the range, and sell a call below the low of the range—say, a $325 call option and a $225 put option. (Traders can adjust the strike prices to their desired level of reward/risk.) The resulting “short strangle” position would turn a profit if the stock remained between these strike prices until expiration. The flipside is that losses are theoretically unlimited in the event the stock stages a trend, breaks out of the range and keeps going.

The following chart shows the profit/loss profile for a short strangle consisting of selling five August 3 $325 calls and five August 3 $225 puts:

ANET short strangle profile. Reward vs. risk

Source: OptionsHouse

The lower left portion of this chart also highlights one possibly overlooked risk of this type of trade: ANET’s next earnings release is scheduled for August 2, one day before the options are set to expire. A huge move by the stock on earnings (not out of the question) could drive up IV—and thus, the options’ prices—reducing any profit the trader may have had in hand at that point.

It may seem like a small risk, but traders don’t get paid for ignoring the little things.

 

Click here to log on to your account or learn more about E*TRADE's trading platforms, or follow the Company on Twitter, @ETRADE, for useful trading and investing insights.