Using options to bet on stocks going up or down

The last risk, of course, is that the US government could default on its debt because Republicans and Democrats seem to have forgotten that politics is the art of compromise. If America runs out of paying its bills, the global economy will enter uncharted territory because the world’s most trusted government will no longer be trusted.

Most days, the stock market acts like a whirling dervish, only to close near the open. But recent intraday swings have become so intense that investors have to wonder what would happen if the market suddenly became overzealous or bullish.

It’s hard to be certain about the direction of stocks when exogenous risks such as inflation, the specter of a recession, the pace of Federal Reserve rate hikes and the debt ceiling crisis are driving market volatility. Rather than debating whether the VIX is broken, a popular market topic, it’s better to look at strategies that can benefit from changes in options volatility that accompany sharp moves in the stock market.

with

SPDR S&P 500

exchange-traded fund (ticker: SPY) at $410.25, aggressive investors can buy the ETF’s August $400 put option and buy the August $430 option to suggest the stock market will break out of its trading range by summer. The trade is worth about $14.22. For example, if the ETF is at $470 at expiration, the $430 call is worth $40. If it is $350 at expiration, it is worth $60.

The August deadline was chosen to provide a margin of safety that gives Washington enough time to decide whether or not to make a deal. The June 1 deadline, set as the day the government runs out of money, could be temporarily extended, for example, as a dramatic part of the negotiations.

A stranglehold strategy, that is, buying on the rise and on the decline, with different strike prices but similar timeframes, is suitable for investors who can afford to lose money without negatively affecting their daily lives.

The risk of the choke strategy is that the money spent on the put and call will be lost if the SPDR S&P 500 ETF does not substantially fall below $400 or rise above $430 by August expiration. Some residual value will remain, of course, and positions may be rolled over or adjusted to more distant dates. But managing failed positions can cost more to keep them alive.

The strategy represents a sharp departure from our standard position that investors use options to get paid to be long-term investors. We advocate the use of cash-backed trades and covered calls to receive payments from the options market for agreeing to sell or buy stocks at lower and higher prices. We recently wrote that investors can use these strategies when the blue-chip stocks they own or want to buy are decidedly lower or higher.

The stranglehold strategy is related to the central fact of this chapter in the market. relatively low volatility and a stock market that seems to be waiting to break out of a trading range. McMillan Analysis, an options strategy firm, recently advised clients that

S&P 500:

The trading range remained between 3800 and 4200. Recently, the index was around 4,100.

Stephen M. Sears is president and chief operating officer of Options Solutions, a specialty asset management firm. Neither he nor the company has a position in the options or underlying securities mentioned in this column.

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