The major US equity indexes have certainly had impressive runs this year and if you've been long, you've likely done very well. As 2012 comes to an end, the question inevitably becomes, will it continue into next year? With the Fiscal Cliff looming, investors are right to be nervous regarding the outcome. Regardless of how the Fiscal Cliff turns out, or which way the market trades in response, we can use options to profit. With the VIX trading around 16, options are cheap to buy for protection or to make an inexpensive directional bet. If the VIX spikes on Fiscal Cliff worries, we can use these strategies to sell even more premium, taking advantage of increased decay that comes with selling options with increased volatility.
This column from Options Trading IQ will take a look at some strategies that will express various viewpoints on the iShares Russell 2000 Small Cap ETF (NYSEARCA:IWM) for May 2013 expiration. I chose May to allow the market to digest whatever Fiscal Cliff resolution comes (or doesn't). We will take a look at some unambiguously bearish trades as well as some bullish ones and even neutral trades that will generate income if IWM consolidates at current levels.
The idea of these trades is to express varying viewpoints on the market and in particular, its high beta index, the Russell 2000. You can use these trades for current income, to express a viewpoint or to hedge against a long or short position.
As always, you must perform your own due diligence before placing any trades. In addition, these are meant as information only and not formal recommendations. All option prices quoted are the midpoints of the Bid/Ask at the time of writing.
Also note, all max profit and max loss calculations only include the range of prices of 65-95 on May 2013 expiration. Some of these trades have technically unlimited risk but for simplicity's sake, we are only considering the range of prices of $65 to $95. If the price of IWM does reach the extreme end of the graphs, you'd want to close these trades out long before then anyway. Note, the graphs don't necessarily show $65 to $95 but are set up to most effectively portray the profitable range of the trade.
First, we'll take a look at some trades for those traders who think the IWM will fall in the next 6 months. Alternatively, these trades could be used to hedge long stock positions. Keep in mind, at the time of writing, the IWM is trading hands for $83.52 (six month chart is below).
May 2013 72/80 Bear Put Spread
Our first trade is a simple Bear Put Spread. This involves buying one 80 Put ($3.31) and selling one 72 Put ($1.38). This trade is low risk/low reward and doesn't require a lot of margin. You can also see that if IWM falls precipitously between now and May, this trade's max payoff is three times the max loss. In exchange for that, you need IWM to be below $78.00 on May expiration. Here are the specifics:
|Max Loss||(1.92) @ 80.00|
|Max Gain||6.08 @ 72.00|
May 2013 72/80 Short Strangle
Our next trade is a 72/80 Short Strangle, which involves selling one 80 Call ($5.82) and selling one 72 Put ($1.38). This is a bearish trade that pays off over a generous range of prices at expiration. It is profitable anywhere from $64.80 to $87.20, with max profit occurring anywhere between $72 and $80. This trade does require more margin because you are short two options but the efficacy is in the range of profitable prices. Here are the specifics:
|Max Gain||7.20 @ 72.00-80.00|
|Break Even, UP||87.20|
|Break Even, DOWN||64.80|
May 2013 70/79/83/93 Iron Condor
This trade is for the neutral to bearish trader on IWM. It is profitable over a wide range of prices but does require a decent amount of margin. It provides a substantial credit upon open and is intended to provide income to the trader. The trade is: buy one 70 Put ($1.11), sell one 79 Put ($3.00), sell one 83 Call ($3.98) and buy one 93 Call ($0.54). Here is the risk/reward:
|Max Gain||5.34 @ 79.00-83.00|
|Break Even, UP||88.34|
|Break Even, DOWN||73.66|
May 2013 Short 83 Straddle
This trade is for the truly indifferent trader, betting simply that IWM won't end May any different than it is now. It involves selling one 83 Put ($4.51) and selling one 83 Call ($3.98). This trade is profitable over a wide range of prices again but realizes its max gain only at exactly $83.00 on May expiration. Here is the risk/reward for this trade:
|Max Gain||8.49 @ 83.00|
|Break Even, UP||91.49|
|Break Even, DOWN||74.51|
May 2013 80/85 Short Strangle
Our next neutral trade is the 80/85 short Strangle, which involves selling one 80 Put ($3.31) and selling one 80 Call ($2.96). This trade provides a large credit on open in exchange for some margin and potentially unlimited losses if IWM experiences a huge move in the first half of next year. It also has a wide range of profitable prices. Here are the specifics:
|Max Gain||6.27 @ 80.00-85.00|
|Break Even, UP||91.27|
|Break Even, DOWN||73.74|
May 2013 84/92 Bull Call Spread
This is a simple bullish play with limited risk and reward and small margin requirements. It involves buying one 84 Call ($3.46) and selling one 92 Call ($0.71). There is a lower probability of this trade ending up in the money but it is also very low cost. Here is the breakdown:
|Max Loss||(2.75) @ 84.00|
|Max Gain||5.25 @ 92.00|
May 2013 74/83/86/93 Iron Condor
Our last trade is neutral to bullish and involves buying one 74 Put ($1.74), selling one 83 Put ($4.51), selling one 86 Call ($2.50) and buying one 93 Call ($0.54). This trade uses some margin because you are short two options but the usefulness is in the large breakeven range of $78.26 to $90.74. It also provides a substantial credit upon open and is intended to provide income to the trader. Here are the specifics:
|Max Gain||4.74 @ 83.00-86.00|
|Break Even, UP||90.874|
|Break Even, DOWN||78.26|
We have seen several trades ranging from bearish to bullish and in between that use varying levels of margin and have varying break even points and profitability ranges. Regardless of your market outlook, you can use these structures to express your viewpoint out to May of next year. In addition, you can move the strike prices around to suit your personal tastes and margin requirements. Finally, a trader that is long or short the ETF itself can use these structures to hedge their position against losses and provide current income in the process.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.