Measured Move Trading

 

The markets seem to be taking the shut down rather calmly, at least for now. Of course, we've seen shutdowns before. Today's NY Times has a handy guide to how markets have performed in past shutdowns.

That isn't what scares me personally as a long time veteran of the capital markets. We've been here before. What frightens me is the prospect of a failure to raise the debt ceiling by October 17. We've never been there before. This could definitely seriously affect the entire global financial system. Slate.com has a good article on why this is so scary. And another NYT piece explains why it could even be potentially  catastrophic.

However, if the worst does not come to pass the markets will very likely settle down quite rapidly and if you believe that to be so then I would like to discuss an appropriate options strategy.

As I've discussed before the at the money straddle shows, in its wisdom of supply and demand, where the market believes the trading range will be.

Let's take the S&P ETF (SPY). With SPY at 168.50 (equivalent to 16850 in the S&P 500) we'll use the 168 straddle in October. This straddle is trading at 6.50 (3.50 in the call, 3 in the put). This implies that the trading range until October 19 will be 161.50-174.50. Those are the measured move targets.

We can sell that straddle naked and hope the market is right, which would be foolish, or we can believe the market is right and still protect ourselves by buying the 175 call at .50 and the 161 put at 1. Long time readers will recall that this strategy, short straddle, long strangle, is called the Iron Butterfly.

If the market is correct SPY stays with in its measured move targets this strategy makes 5 points, or $500 for each Iron Butterfly. If the market is above 175 or below 161 on expiration you lose 2, or $200 for each Iron Butterfly. So, we see that this is a very favorable risk vs reward options strategy.

Hopefully you are using a trading platform that would let you put in this complex strategy as one limit order. I would never "leg into the trade" by first selling the straddle and then buying the strangle. As in all strategies I believe in limit orders and doing the trade on my price or not doing it at all.