Trading a Quiet Market (originally posted 6/25/13)

A good recovery is going on right now with the Dow up 100 and gold stable. However, beware of counter-trend Tuesday! A resumption of the down move tomorrow would not be a surprise. Basically, that might leave us unchanged or nearly so for the week.

When the market has a few violently swinging days volatility explodes as people are suddenly afraid to sell premium (they'll sell the VIX at 13 but not at 21. Don't tell me that markets (or at least the people in them) are rational! Then what often happens after everyone is protected against more price swings is the market settles down and premium collapses like a bad souffle.

Just as I like buying when the market is down and selling when it's up (hey, I'm a natural born Contrarian) I like to buy premium when it's cheap and sell it when it's expensive. In other words, try and anticipate the market settling down without taking undue risk. And a great way to do this is by an old favorite options play of mine, the Iron Butterfly (IB)

The IB can basically be seen as being short the straddle and long the straddle. Ideally, you want the entire trade to expire worthless right on the short strike. That makes the maximum profit the premium received and the maximum loss the difference between the strikes minus the premium received. Remember, all strikes must be equidistant. For the trade to be non-directional the short straddle should be at the money. Moving the straddle up or down slightly tweaks the directionality of the trade.

Let's take a real life example. AAPL has been flying around and is now trading at 401.50. If we think the stock will stabilize at 400 we can sell the July 400 straddle at 23.50 (12.50 in the call, 11 in the put) and buy the 380/420 strangle at 8.50 (4.50 in the 380 put and 4 in the 420 call). This gives us a maximum profit of 15 if we expire at 400 and a maximum loss of 5 if we expire under 380 or over 420 for a nice 1:3 risk reward ration. And we have two break even points, 385 and 415.

Take the market as whole using the SPY (S&P 500 ETF). With SPY at 158.15 we can sell the July 158 straddle for 5.70 and buy the 153/163 strangle for 2. At 158 we make 3.70 and under 153 or over 163 we lose 1.30 with break evens at 154.70 and 159.30. We can see that both these trades are hedged with good risk reward ratios.

Don't try and duplicate these exactly as they are time and price specific. Once again, this is a way to help think about how to trade a market that you think will settle down after some violent price movements.


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