Following 2013's staircase-like move higher, the trading action thus far this year has been a bit more lateral. Marty Kearney, from the Chicago Board Options Exchange (CBOE), offers up a few options strategies that may be useful if sideways market action persists.
One strategy to consider in a sideways market is selling put options. You can sell calls and puts to generate income—including a variation of selling calls known as the covered call—yet selling puts is an interesting strategy if you’d like to generate income and you wouldn't mind purchasing the stock if it fell to a lower price.
Kearney: “People generally sell puts for two reasons. Number one: to generate income. Number two: to set a price—below the current market price—where they wouldn’t mind owning the shares. This is an income-generating strategy that can be especially beneficial for investors who may have missed a stock’s move up and wouldn’t mind buying it if it came down a bit. Plus, if the price doesn’t fall and you don’t get the stock, the consolation prize is the cash from selling the option.
“Let’s look at an example. Suppose a stock that you do not own is trading at $50, but you wouldn't mind buying it if it went down 10% (to $45). If you wanted to own the stock, you could put in a bid at $45 to potentially buy 100 shares. Alternatively, you could sell the 45 strike price put, with no protection (known as a naked put). Here, if you did sell the 45 put, you would have an obligation to buy the stock at $45 if the option were exercised. However, let’s say you collect $1 in premium. In this example, if the stock doesn't get to $45, you get to keep $100 ($1 premium times 100 shares for the put option contract). If it goes below $45—which is the point at which you may want to own it—you are buying it at $45. But remember, you collected $1 for selling the option. So, you are effectively buying the stock at $44."
Note that this is a naked put, and Fidelity customers will have to meet the appropriate margin requirement.
Another income-generating strategy that involves selling options is the covered call. Now, investors can use the covered call strategy at any time, rather than just when there’s sideways market action. Nevertheless, Kearney suggests covered calls may be particularly useful in markets like these.
Kearney: “The premise of a covered call is, you own shares of stock, and you’re selling a call on the same stock. One advantage of owning the stock of an option you are selling against is that there’s no margin, because you have the shares as collateral. If the stock doesn’t move, which it might not in a sideways moving market, you get to keep the premium.
“If the stock goes above the strike price you choose, you may have to deliver the stock. But this is a relatively conservative options strategy. You can even do this in a retirement account at Fidelity.”
Selling puts and covered calls are relatively straightforward strategies that, with a little practice, most investors should be able to learn. The iron condor is a more complex strategy, for the advanced options trader.
To construct an iron condor trade, you create two credit spreads—one above the current market price and one below. The purpose is to take in cash from both credit spreads under the assumption that the stock won’t move much in either direction and that all the options will thus expire worthless. Kearney says that because of how the iron condor is constructed, it can be an attractive strategy for a sideways market.
Kearney: “An iron condor is a credit spread strategy: You take in income at the outset. Let’s look at an example of a stock that is currently trading at $50 to illustrate how you might construct this position. First, you might be interested in selling a call with a 55 strike price on a stock you don’t own and don’t think will go higher. In order to reduce the margin associated with this trade, you might decide to buy a 60 strike price call, which creates a credit spread.
“As long as the stock doesn’t go above 55, you are in great shape. If it does go above that price, you may lose money on the trade. But at least you know your risk is limited if it goes to, say, 70 or 80, because you purchased that 60 strike price call for protection.
“In addition to this spread, you might sell the 45 strike price put and buy a 40 strike price put to complete the iron condor. Thus, if you sell a 55 call and a 45 put, the stock could move 10% in either direction and you still get to keep the income created by both credit spreads, because those options expire worthless. Plus, you have protection from sharp moves in either direction due to the options you purchased in each credit spread. But remember, in a sideways market, you are expecting the market, or a specific stock, not to move that much. Consequently, this may be an appropriate strategy for that type of market.”