Market-neutral strategies earn a profit when time passes and the "magic" of time decay (Theta) does its thing. Of course, it is not as simple as opening a position and waiting for the profits to accumulate. There is always the possibility of a profit-destroying price change in the underlying stock or index.
Nevertheless, these strategies work well when the markets trade within a narrow price range. The beautiful characteristic of these versatile option strategies is that they can be used by the bullish or bearish investor as well as by the market-neutral trader.
- Calendars, iron condors, and butterfly spreads provide examples with positive time decay for the bullish or bearish investor.
- The calendar is used by traders who believe that the stock price will remain near its current price when a specified expiration date arrives.
- Just as you can shift the strike price of a calendar spread to compensate for your market bias, you can do the same thing with an iron condor.
- Instead of buying an at-the-money butterfly, buy one whose middle strike price is above the market when bullish, or below the market when bearish.
ABCD is currently trading at $65 per share. Believing that the stock price will rally towards $70 as the Dec. 18 options expiration date approaches, you buy an out-of-the-money calendar spread.
Traditionally, the calendar is used by traders who believe that the stock price will remain near $65 when a specified expiration date arrives. But there is no reason why it cannot be used by traders who believe that the stock price will differ at expiration. One advantage of using the OTM calendar spread is that it is less expensive than an ATM (at the money) spread.
- Buy six ABCD Jan. 15 70 calls
- Sell six ABCD Dec. 18 70 calls
As times passes and the stock moves towards $70 per share, the position becomes more valuable and you earn a profit. That profit is maximized if the stock is almost exactly $70 per share on Dec. 18. At that time (or earlier if you wisely do not attempt to earn the maximum theoretical profit) you close the position by selling the calendar spread.
If the stock price does not conform to your expectations, then the spread will lose value as the December calls expire (and become worthless). You can keep your Jan uary calls, hoping for a miracle, but it is often wise to sell the call and recover some of the cost of buying the spread.
When implied volatility is relatively high, the profits are even larger than anticipated. When implied volatility is low, the profits are reduced.
Just as you can shift the strike price of a calendar spread to compensate for your market bias, you can do the same thing with an iron condor.
In the following example, assume that an imaginary index is trading at 1,598 and that you are bearish over the near term. The following is just one example of an appropriate iron condor.
Instead of centering the IC around the current index price (~1,600), you may decide to center it around 1,520 to accommodate your bearish bias:
- Buy three INDX Jul. 17 1,440 puts
- Sell three INDX Jul. 17 1,450 puts
- Sell three INDX Jul. 17 1,590 calls
- Buy three INDX Jul. 17 1,600 calls
Because of the bearish bias, you may sell calls that are already in the money (as they are in this example). If that bothers you, choose different strike prices. However, the premium for this iron condor is high because the call portion should be trading above $5—and that means your possible loss would not be too large if it turns out that your bearish prediction was wrong.
Some would advocate trading all four legs of an IC at one time, but if truly bearish you could sell the call spread now, intending the sell a put spread after the market declines. But be careful: If the market rallies you may never get to sell the put spread, and that means your loss is higher than it would have been—had you sold a put spread and collected some additional premium.
You get the idea by now. Instead of buying an at-the-money butterfly, buy one whose middle strike price is above the market when bullish, or below the market when bearish. This is a very inexpensive way to play your bias.
Example: You are bullish and ABCD is trading near $65 per share.
- Buy two ABCD Dec. 18 65 calls
- Sell four ABCD Dec. 18 70 calls
- Buy two ABCD Dec. 18 75 calls