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Options ideas for a flat market
This article appeared in the October 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
If your view is that a stock will stay flat or trade in a range what do you do?
By Tony Hunter, ASX
You don't need me to tell you we have had a "difficult" market for quite some time. Up a bit, down a bit, goes for a run for a while, then retraces. Essentially drifting and waiting for things to be sorted out in Europe, America, China, the hung parliament - you name it.
Most investors hate times like this, but a flat, drifting market is perfect for some options strategies and ASX has launched a new free online course that covers some of them.
The buy write (bought shares plus a sold call option) is a very popular strategy that allows you to earn extra income on your shareholding. However, it has a capped upside so it appeals to investors in markets that are flat or gently trending upwards. It does not work so well when everything is going gangbusters.
You can look at the free online buy and write module from our Introduction to Options course.
Once people get more experienced with options they start to see the flexibility and opportunities presented by trading various combinations of them. These are referred to as multi-leg strategies. For example, selling straddles or strangles can be a good way of profiting in a flat market.
If you have a view that a share, or the whole market, is going to trade within a range then one approach is to sell a call option and also a put option. If your view is on a particular company you would use options over its shares; if it's a market view you would look at XJO options, which are over the S&P/ASX 200 index.
How it works
Suppose you have a view that a share is going to stay around $10. By selling a $10 call and a $10 put you earn two lots of premium. In a flat market you will have earned premium income despite the share price not moving. Every move away from $10 is eating into your profit so your tolerance will be the amount of premium income earned.
Why is it called a straddle? Well the payoff diagram looks like this one below so you can easily imagine it as someone straddling a horse or a fence.
Suppose your view is not so precise and you think the share or the market will trade within a particular range. You might consider a strangle. It sounds horrible but it is just a straddle with different strike prices for the respective legs. Suppose you think the shares will trade in a range of $10 to $10.50. A strangle to reflect this view would be to sell the $10 put and the $10.50 call.
Another attraction is that because you are selling (writing) options you are being paid to implement your view. The risk, of course, is the market breaks out in one direction or the other, resulting in a heavy loss on one leg that completely blows away any money you made via premium income. And remember that you will be paying more brokerage by transacting multiple legs.
Why is it called a strangle? Well, from the payoff diagram you could make a case that it looks like it is looping around. But if that is the reason for the name, I don't find it as convincing as the straddle. Anyway, that is what they are called.
The opposite situation
Suppose a significant economic event is imminent, say something to do with Europe. You are not sure how the market will react but think it might go up a lot or it down a lot; you are confident it will react strongly. You might consider buying a straddle or a strangle.
The strategy will cost you money to implement because you are buying two legs - a call option and a put option. You will need the market to move enough in one direction for the profit on that leg to at least cover the premium you paid for the two legs plus any brokerage and exchange fees incurred.
If the market does not react, or react enough, your maximum loss is the premium you paid. Your upside is potentially unlimited, confined to how far the market can move either up or down during the life of the options.
These are very high-level descriptions about how options can be used to give effect to a particular market view. But if you want to start using options you should really have quite a bit of experience in share trading - these are leveraged instruments, after all. You need to be confident with mathematics, be prepared to keep a close eye on your positions and adjust your strategy as circumstances change.
We recommend novices start with ASX's Introduction to options course but if you have already done it or have done some basic options trading, we hope you will have a look at our new Advancing in options course.
The course explains writing options and your potential margin obligations, what is involved in implementing multi-legged strategies and the types of strategies you can consider for various market views. No registration is required, it is free, and you can work through the modules at your own pace and in the order you prefer.
Why not have a look now?
About the author
Tony Hunter is head of investor education at ASX.
Those new to options should consider the ASX's Introduction to options course. It is designed to help investors understand the features, benefits and risks of exchange-traded options, and introduce various options strategies - all in a stimulating, interactive learning environment.
The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.
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© 2013 ASX Limited ABN 98 008 624 691