So the S&P 500 has been more or less range-bound after having a nice move upwards. Traders and investors can find this to be very frustrating, as individual stocks may not move at all, or broad-market ETFs make as much forward progress as Granny in her rocking chair. Here’s how options can help.
The simplest strategy is to just buy shares of the SPDR S&P 500 ETF (NYSE: SPY) and sell covered calls against it. So let’s say you buy it at $139 and sell the June 140 calls for $3.05. That generates about a 3% return if it’s called away. If it isn’t, there are worse things than holding the S&P 500 for the long term, as a piece of a diversified portfolio. You could also set a stop loss to make sure you don’t get too badly hurt on the downside if the market crashes.
Another way to go is to buy the underlying ETF and buy a put. In this case, if the market rises, you aren’t giving away any of the upside. The beauty of the married put is that you are protected if the range-bound market cracks open like an egg and falls precipitously. Now you are protected on the downside by at least a 1-to-1 ratio. You can currently buy the June 139 put for $4.10.
Then we have a very complex strategy, but it’s designed to essentially remove the market risk altogether and allow you to enjoy a limited return. It does assume the range-bound market situation will continue, as it depends on a lack of volatility between execution and expiration. The strategy has the pretty and rock-and-roll name of the Iron Butterfly.
For options sophisticates, that means it’s a short straddle and a long strangle combined. For options newbies, that means a short at-the-money call and a short at-the-money put, both at the same strike (short straddle); and a long out-of-the-money call and a long out-of-the-money put (long strangle). The at-the-money short straddle is where you pick up the maximum reward potential, and the maximum risk you take on is the width of the spread less the premium received.
Let’s take a hypothetical example.
The SPY is trading at $139. So you would:
- Sell the May 139 call for $2.60
- Sell the May 139 put for $2.70
- Buy the May 138 put for $2.30
- Buy the May 140 call for $2.00
The net credit would be $1.00 for each one of these Iron Butterflies. Now, as I said, this is limited return (0.75%) with limited risk. If you want to increase your return, but also increase your risk, you can buy the March 137 put for $2.00 and buy the May 141 Call for $1.55. Now your return is 1.3% but you’ve exposed yourself to slightly greater risk.
As always with options, so much depends on what your own bias is towards the market. How convinced are you of your own prediction as to the market’s behavior?
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Capital, Inc., which brokers secure high-yield investments to the general public and private equity. You can read his stock market commentary at SeekingAlpha.com. He also has written two books and blogs about public policy, journalistic integrity, popular culture and world affairs.