One way or another, active traders are typically trying to determine which direction a market will go in the near term. But what about when prices may not be going anywhere? Those are times options can be handy.
Facebook (FB), for example, has had a tremendous run since its 2012 launch (+378%), and last year’s 53% rally was more than solid. But the following chart also shows that the lion’s share of that move occurred in the first seven months of the year: The stock has climbed only around 5.6% since July 28—a far cry from the 49.8% it gained up to that point in 2017.
The stock scratched its way to a record high of $195.32 on February 1, but then corrected to $167.18 on February 9—a $28.14 range that includes almost all the price action dating back to July 28. In fact, only one day (September 26) traded entirely outside this range.
A trader mulling over this situation may consider the fact that FB, while maintaining an overall upside bias, has had trouble establishing a clear uptrend in recent months. Also, there appear to be few catalysts on the near-term horizon with the potential to launch a big move. Facebook has had its share of trials recently, including fallout over Russian election trolling.1
At the same time, one could argue the stock has performed pretty well given its challenges, and there’s no reason to think the stock is headed for a meltdown (it’s still Facebook, after all). So, maybe it will keep doing what it’s been doing for a while.
In such a situation a trader could consider trading a short “strangle”—selling a call option with a strike price above the current stock price while also selling a put option with a strike price below the current stock price.
If we expect FB to continue to trade mostly sideways—but also accept the possibility that it could slightly penetrate either side of the of the $167.18 – $195.32 range defined by the February high and low—we could sell a call option somewhat above this range and sell a put somewhat below it. Let’s say we put on a short strangle by selling the April $205 call and selling the April $155 put, which expire on April 20 (30 trading days from now). The following chart, generated by TradeLab, shows the profit-loss profile for a five-contract position:
Source: OptionsHouse (TradeLab)
Midday yesterday the April $205 call was trading around $0.49 and the April $155 put was trading around $0.52, which means a trader would receive a $1.02 credit ($101 per strangle) for establishing the position. As long as FB stock remained between $155 and $205 through April 20, a trader would keep this credit.
One of the advantages of a short options strategy is that “time decay” is on your side—options naturally lose value as time passes, and that depreciation accelerates as expiration approaches. Also, high volatility (which FB has recently experienced) tends to inflate option values. But there are trade-offs to consider:
●Reward is capped. The maximum profit is the credit you receive from selling the options. If the stock price remains between the two strike prices until expiration, both options will expire worthless and you keep the money.
●Risk is (theoretically) unlimited. This means you’ll need to cover one of your option positions if the stock price pushes above your call’s strike price or below your put’s strike price. If you don’t, you run the risk of losing money on your options or having to take an unfavorable position in the underlying stock.
But in the right situation, a short strangle can be a way to profit from a market that’s going nowhere. For a lot of traders, that’s a welcome change of pace.
1 Barron’s. Facebook Dinged In Lawsuit, Report Card, Upcoming Documentary. 2/7/18.