Aug 12 2008
Stagnant Can Be Sweet
To me, what really makes stock options so fantastic is that a trader can make money from companies who are dead in the water and going nowhere fast. As a matter of fact, there are many more stocks in a sideways or stagnant period than there are stocks moving up or down.
There are many ways to make money trading stagnant stocks. The idea is to sell (write) options to other traders who believe that the stock may move and if the stock doesn’t move into the money to the extent of being exercised, the stock option will expire worthless. In this way, the option writer can keep the premium. The profits from premium collection aren’t usually very high, but they can be very repetitive. If the stock option has some implied volatility, that will help to boost premium prices and premium prices are what an option trader is after when it comes to stagnant stocks.
There are many strategies for stagnant stocks but perhaps the simplest one is to write a covered call. But there are others-such as the poetically named “butterfly” that really works well with stocks that are stagnant but with some implied volatility.
For example, suppose IBM came off an excellent quarter and prices had moved well to the upside. The stock has now moved into an over bought condition as indicated by the RSI. Moreover, there is no more anticipated good news expected to be released soon about the company. The stock has moved sideways and is still above its 30 day moving average. The near term probabilities of the stock moving up are not as high after the stock price has discounted the good news. Now might be a good time to put on a Butterfly.
If a trader is trying to collect premium but wants to protect against any unforeseen factors that might make the stock move, a butterfly offers some nice insurance protection. Here is how it works. If the price of IBM has stabilized around $110, a trader would put on a long Butterfly by purchasing one in-the-money IBM call with a strike price of $107. This protects against unexpected upside moves. Then the trader would sell two $110 IBM calls. As the highest premiums are usually found at-the-money, the selling of two contracts near or at-the-money boosts the premium and helps to offset the long purchases. To also help protect against a move above the selling prices, another one long IBM call is purchased at $112 strike. If the price goes, down, not a problem; the middle sold options will expire worthless and the premiums minus the premiums for the two calls can be kept. If the price moves up and into-the-money, the in-the-money long call and the out-of the money long call will help protect the position. The Butterfly is considered to be a very conservative strategy. Keep in mind that there are a total of four options purchased in the same month. The center two are sold for premiums and the bottom and top long calls acts as protection against counter moves.
A simpler strategy, which accomplishes about the same thing, is to buy the stock and sell the option. This is called a covered call. It is also hedged like the butterfly, but this strategy requires more capital than that of the conservative Butterfly. This is because to initiate a Covered Call (buy-sell) requires that the stock be owned outright and a call be written.
Another way to capitalize on a stagnant stock, which lies somewhere in complexity between the Butterfly and the Covered Call is to sell (write) an at-the-money call and then purchase another cheaper out of the money option call-also in the same month (a spread). Of course the spread between the premium collected for the sold ATM call, OTM call premium paid and transaction costs must justify the trade.
For more information on fantastic world of stock options, contact Options Universtiy at Options University.
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