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Trading Index Options
The Smart Profits Report: Issue #260
Friday, November 18, 2005
Trading Index Options - Two Ways To Profit
By Steve McDonald
Options Specialist, Mt. Vernon Research
In the 20-plus years I’ve been trading index options and stocks, it seems the market always runs when you least expect it. Consider how long it’s been since we’ve had any good news. Not just about the market, but good news in general - Hurricanes, interest rate hikes, volatile gas prices, wars in Iraq and Afghanistan.
We’ve spent five years in a lackluster market, and it hasn’t been easy to hang in there. But every bit of my market sense tells me we are on the verge of a great ride…
- Corporate earnings reports have been exceeding estimates two to one.
- The Fed has done a great job of controlling inflation.
- Energy prices are back to a reasonable level.
- Interest rates are still at historic lows.
This looks like a very good place to start a run in stock prices.
Still, we’re not quite there yet, and a haunting voice in my head is whispering caution. In the meantime, then, how do I take advantage of uncertainty, without losing the farm?
In a tough market like this, index options are a great way to come out on top by using less cash up front. Let’s look at two ways to trade them for a profit…
Naked Calls and Strangles for Index Options Profits
The Nasdaq 100 Trust (Nasdaq: QQQQ) is the best way I know to follow the ups and downs of its namesake index. And it can be very volatile, which is good for trading.
The following is a play that makes a lot of sense to me for this type of market. (As always, this is just an example, meant to illustrate some of the techniques and mechanics of using this option. It is not a recommendation.)
On November 2, QQQQ was trading at $39.19, and we’ll use the pricing from that day in our example. Since we don’t want to be too aggressive and outsmart ourselves on the time value, let’s go out about eight months, to June of 2006, and look for an option in- or near-the-money.
The June 2006 call, with a strike price of $41 (QQQ FO), was trading at $1.65 on November 2. That’s a good buy because the strike price was $1.81 from the current price of the shares, which means you’d get a discount of 16 cents. If you wanted to be right at-the-money, you could have looked at the $40 strike for $1.95, but this had a hefty premium to it.
For a classic valuation, the QQQQ would have to move 4.6%, or $1.81, between now and June to reach our strike of $41. If I’m right about the market sitting on the edge of a solid run, a move of $1.81 in eight months is more than reasonable. Ideally, we’d like to see a move beyond the $41 price, which would give us a dollar-for-dollar move in our option above the $41 price. So, if the QQQQ moves up to $44, our option should be worth $3 from $1.65, plus any time value - an 81% gain in eight months.
That, of course, is if the market plays out the way I think it will. But what if you don’t see the market going one way or the other?
That’s where the second way to the index comes in…
How to Use a Strangle to Capitalize on Uncertainty
First, remember that with a strangle, you’re buying the calls and the puts with the same expiration, but with different strike prices.
Since we’ve already bought the call in our example, we need to buy a June put to complete the strangle. We’ll go with a strike of $37 (QQQ RK) that would have cost $1.05 on November 2.
Now that the strangle is in place, keep in mind that the trend is your friend. If the index starts moving up, it’s time to dump the put. Don’t dig yourself a hole by assuming you’re right and the market is wrong. Let the losing side of the trade go, and let your winner run… That’s the key to a strangle.
The QQQQ is only one of the indexes available. If you like the idea of using options to bet on market (or sector) moves, and think you’d like to get away from the tech-heavy Nasdaq, there are numerous ETFs (Exchange-Traded Funds) that allow you to implement the same type of strategy.
The bottom line is when you aren’t positive about the market’s direction, you can use options to play your hunches without betting the farm. I find I sleep better that way.
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Today’s Smart Profits Cribsheet
- For more of Steve’s strangle and straddle tips, revisit Smart Profits #251 and #257
- Lee Lowell, our Commodities Options Specialist at Mt. Vernon Research, explains different ways of trading ETF’s in Smart Profits #230, EMinis & ETFs - "Trade" E-minis With Less Risk Using ETFs.
- You can always use our free Smart Profits Glossary to get up to speed on trading terminology like "strangle" or "index options."
Good trading,
Steve
Related Articles:
- Options Strangle - How to Strangle Profits Out of an Imperfect Market
- Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain
- Take the Big Guys’ Money - With Their Own Weapons
