Profiting From A Rangebound SPY

 |  Includes: IVV, SPY, VOO
by: John A. Sarkett

When considering a new market position, first you forecast. There is never a lack of pundits to advise you, of that you can be sure. Here is what each camp will tell you, in brief:

Fundamentals: the bull case

At this present moment in time, the bulls say, "nothing succeeds like success." Rising markets foster even higher markets. Whether they want to or not, some investors believe they must buy, or miss out. So the momentum is with the bulls.

Noted market prognosticators are calling for higher prices. Laszlo Birinyi recently projected a YE 2013 SP of 1900.

With the wind at their backs, by way of massive, coordinated G20 interest rate suppression and unparalleled liquidity, stocks have nowhere to go but up.

Unemployment declining, though slowly. In last reporting period, from 7.6% to 7.5%. Payrolls increased 165,000 vs. 155,000 expectation.

As for the unbelievers, we have this: markets climb a wall of worry. There are too many still who "don't believe" for markets to crash and burn here.

Fundamentals: the bear case

The bears say, 'wait a minute, bulls.' You got that right about worldwide liquidity, but we call it 'currency debasement.' And that, historically, always ends badly.

Corporate earnings growth is slowing, according to research analysts at Thomson Reuters. Sixty-nine percent have so far beat analysts' earnings targets, but more than half have missed sales projections, Harrison said.

Earnings can be managed, but not revenues and companies are not beating their revenue forecasts (with more than two-thirds of companies reporting Q1, less than half beat revenues forecasts).

Furthermore, they say, there is a pattern here, and it is not a good one. We are following the script from 2010, 2011, and 2012, i.e. strong start to year, then fade. Turning down of late: purchase manager surveys, retail sales, employment, durable goods and consumer sentiment. As a result, in 2012, stocks slid 10% in just eight weeks. Is that what we have to look forward to this year?

Market titans like Leon Black, CEO, Apollo Global Management, (Apollo Global Management (NYSE:APO)") are selling here, not buying, according to remarks made at the Milken Institute's global conference in Los Angeles and reported in Barrons.

See this presentation for a plethora of bearish stats.

What if you believe both?

So we have strong arguments on both sides. What if you're persuaded by both - equally? That is, you foresee the bull-bear battle to seesaw on for some weeks or months to come? And a range-bound SP500?

One man's Rx: don't just do something, stand there. Right between the bull camp and the bear camp.

Taking this approach, you can generate significant profits, according to Dan Sheridan, founder, Sheridan Options Mentoring, and 22-year CBOE pit trading veteran. Interviewed by email, he recommends a delta neutral strategy ("delta" means change), such as an iron condor or single or double calendar. Both are options bets that the market will stay in a range, and that's how it will profit. He puts it this way: "We go by the motto 'Trade the trade and not the market.' So we are thoughtfully, pre-meditatively playing a range, having a plan and profit target and trying to get out as quick as we can.""

An iron condor is a pair of debit spreads: sell a call, buy a farther call, sell a put, sell a farther put. A calendar spread is to sell a near expiration option, buy one farther out. Both strategies generate which options geeks call "theta," i.e. options decay. Since you sold the option, that faster its value declines, the more you earn.

Why be neutral? Because sometimes the market does what it wants, despite your "reasons." You can have a list of bear arguments longer than your arm, and they each may be "right," but lately the market keeps moving higher. As long as it doesn't move "too high," with delta neutral strategies you can still profit. If it does move "too high," you can make "adjustments," and still profit, too. More on that later.

Here's what Sheridan recommends at this moment in time. We'll follow along this trade in subsequent installments, so you can see how it may be adjusted, and in the end, whether it is a profit or loss.

He cautions, however, one month, win or lose, does not a strategy make. "With a delta neutral strategy, you have to be there month in and month out, and you have to plan your adjustments in advance," he says. "We leave nothing to happenstance, this is a business and as such, we manage it. Not too many have the discipline to do that, but those are the ones who succeed. There is power in consistency."

Here is Sheridan's current delta-neutral trade, a calendar spread. He chooses a calendar spread because it works well in a low volatility environment, which is where we are (VIX = 12.90, low on absolute historical basis, and low within recent range, see chart below). Slowly rising volatility increases the value of the long option, more than the short option, so you have volatility (which the pros call "vega") working for you. (There is always a caveat in options, and Sheridan cautions: "but not if the market goes down fast, then volatility will rise more in the short than long option.")

Any broad index can be used ($RUT, $NDX, $SPX, DIA ("SPDR Dow Jones Industrial Average (NYSEARCA:DIA)"), or market bellwether of your choice, ("IBM (NYSE:IBM)") or even ("Apple Inc.(NASDAQ:AAPL)"), but Sheridan likes the SPY ("SPDR S&P 500 Trust ETF (NYSEARCA:SPY)") for its liquidity, and ease of entry and exit. Prices for in and out are usually just pennies apart in the SPY.

The trade: Aug/July 162 SPY calendar. Buy 10 August 162 calls, sell 10 July 162 calls, net debit, .72 or $720 (prices as of Friday, May 3, 2013). That's the most you can lose. You can make nearly twice as much, but we'll eschew being greedy, and aim for "just" 10%.

Here's what it looks like in risk curve or graph:

Click to enlarge

What if the market moves, up or down? Like a good Boy Scout, we will be prepared with orders sitting in the market. If the SPY moves from 162 to 164, or halfway to the at-expiration breakeven point at 166, we will add a 166 calendar. The graph will then look like this:

Click to enlarge

This is not a bad thing. Fond of analogies, Sheridan gives context to adding a second calendar. "We manage calendars like California surfer who adjusts to the different heights of the waves very naturally," he says. "We aren't afraid of price moves, we expect them, and so we roll with them."

It should be noted here, though, that adjustments aren't "free." We have

  • maintained our daily theta but...
  • our maximum profit has declined somewhat from $1500 to $1250,
  • and we have spread our potential profit "tent" one point from 157 to 166 out to 159 to 169
  • but all the above at a cost of another $720 or so in capital.

If the market declines to 160, we would undertake the same adjustment to the downside, by adding a 158 calendar, as follows:

Click to enlarge

The next intervention? Sheridan says: "Once we are in an double calendar we adjust halfway between short strike and expiration BE (breakeven). If it hits adjustment point, we take off calendar furthest away and can move that calendar above the current price on upside or below current price on downside."

In any case, we don't plan to stick around for July expiration. Our profit target on this trade would be 10% of capital outlay. This is a small chunk of the profit "tent" above. To illustrate, if we managed to find ourselves in the middle of the risk curve, that might take only two to four weeks to achieve the 10% return, give or take. At that point, after four weeks in the market, we would be out of the trade six weeks before the July expiration. Once achieve our 10% profit goal, we move on to the next trade, or simply sit out.

Practically speaking, Sheridan says: "There is a good probability, almost 65%, that our calendar won't go outside our expiration BE points over the first 6-7 days. So we may look for 9-10% profit over as early as 5-8 days in a calendar and the probabilities would be more favorable toward success with that type of plan."

Click to enlarge

Sheridan concludes: "The method here is proved - or disproved - over time, trade by trade, month by month. One trade does not a successful (or unsuccessful) strategy make. It is the track record over time. This method does have something powerful behind it: proactive risk management vs. wishing and hoping. A delta neutral trader with meticulous persistence and patience will be amply rewarded."


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.