Making Money in a Neutral or Down Market Using Index Options

Any one can make money in an up market – sometimes it’s as easy as throwing a dart at a financial page! It is the truly savvy, innovative investor who can come up with strategies to aggressively make money when stocks are going nowhere or down, down, down.  In fact, once you understand the nature of option pricing, finding strategies with extremely favorable risk/reward can be much easier in a down market.

Just a brief span through any financial history book will quickly demonstrate that the equity markets have a decidedly upside bias. On average, a bull run can have 4-7 years of upside that is only slightly interrupted by small intermittent, insignificant corrections. In comparison, short downsides are fast and furious, lasting for, in many cases barely a month. However, even extreme downsides usually only last for 1-2 years, with flamboyant recoveries following.  Of course, I am referring to 1987-1989, 200-2002, 2007-2009, and most recently August 24, 2016- November 2016 where the SPX almost returned to it’s all time high reached in May, 2016.

Ultimately, timing is everything, particularly in reference to choosing when to execute neutral or downside strategies. On average in the financial markets, history repeats itself. There are certain months and time frames that have historically had an upside or downside bias. This is one of the diagnostic factors often used in deciding when to create a strategy and which strikes to use. While this cannot be the only tool used, in creating range-trading strategies it is a very valid starting point.

The most important tool in trading index options is the ability to adjust technically and mentally to the changing dynamics of the markets, including macroeconomic factors, technical and fundamental analysis, and seasonality. There is, decidedly, a seasonal factor to index trends. In the past, January, an earnings month, often started the year off with a bang, while February, once earnings were almost over, came in with a whimper and went out a bust. Things have changed. In the past few years, January has started the year with a significant downturn, while February has been the turnaround month. As always, if one digs deep enough, there is, at least, one discernable reason for this – the delay in earnings reporting. Stocks such as Google used to report the day before January expiration on a regular basis, however, now they are reporting the beginning of February. This concept holds true for many of the high tech companies. Since the big boys need to be in for earnings, there is no longer a rush to be in early in January.

In the past, March usually had an upward bias leading into first quarter earnings reporting in April. Obviously, the same holds true for the delay in earnings reporting in April into May. Once again, the seasonality factor is skewed forward, with May, which was once the beginning of the end month of the year, now often the harbinger of the new high for the index. Adjusting to these changing seasonal dynamics is crucial for successful index option trading.

Ultimately, it is often easy to spot a market bubble. The 33% rise in 2013 surely seemed like it took the indexes into bubble territory. Obviously it did, but, just like the story The Emperor’s New Clothes, no one wanted to be the first on the block to admit it.

So here we are, February, 2016, right back where we started in January 2013. And even now, valuations are above normal price earnings ratios, but who’s counting. Will the Federal Reserve, as many analysts are hoping, going to rear its ugly head again and reignite the bubble the markets just barely escaped? More and more of these analysts are agreeing that there is little, if anything, more to be gained from another round of quantitative easing, or, worse yet, negative interest rates.

Time to take the training wheels off and let the economy stand on its’ own two feet.

Potentially time to place some aggressive bearish bets to take advantage of the changing of the guard.

My favorite neutrality or downside strategies are iron condors (IC) or iron butterflies (IB), where a straddle or strangle is sold and wings are bought to cover most of the risk. However, because of the increase in volatility, it has been, all but, impossible to find a viable IC or IB on the SPX index since December. The catch to being successful at these sell-side strategies is choosing the correct strike and month.

For example, in November, when the SPX was back at 2100, the January 1850 iron condor was fetching 90 with a risk of 10. This meant selling the 1850 put and call and buying the 1950 call and 1750 put. One contract of each strike took in $9,000. The best-case scenario was the index closing at 1850 on January’s expiration and you keep your $9,000. The worst case was closing above 1940 or below 1760, which meant you would give back your $9,000 plus another potential $1,000.  Believe it or not, that’s it. As it ended up the index closed at 1866!  How prefect! You kept $7400. Let’s remember what your cost was - $ZERO! Talk about percentage returns.

Of course, that was the perfect trade, and, yes you had to really be thinking out of the box and down in order to have sold that deep in the money iron butterfly. However, even it you did a 1900, 1950, or even 2000 iron butterfly, with adjustment, you would have kept a significant amount of that original money.

As it happened, when the index was in the high 2000’s in December, the January 1850 put was worth $2.00.  I always recommend closing out anything that goes to $2.00.

Of course, you can’t always or even often expect to get the perfect strike as in the previous examples, but with that kind of return you can afford to be wrong sometimes.

As I said earlier, unfortunately, at least on the SPX, recently, I have not been able to find a short term iron butterfly or condor worth the risk, so I just adjust to the next best strategies – directional buy side condors or butterflies with wings and IB and IC sell side spreads with a tail.

Marlene Sackheim, Author

Trader Education