Trading Strategies for Summer Vacation

 |  Includes: DIA, QQQ, SPY
by: optionMONSTER

By Chris McKhann

"Sell in May and go away." That common summertime saying may have some merit as volumes taper off, leaving the market to go to sleep and drift sideways.

Many big traders are on the sidelines, not just recovering from the long holiday weekend but also reluctant to make directional bets in this environment. It is likely that low equity volumes will remain, as the Financial Times noted in a recent article.

One point missing from the story, however, is that option volumes remain robust. Also seeing excellent volume are the VIX futures, as evidenced by record volume in June.

This may be a sign that traders are making bets on volatility even though they are not willing to pick directional moves by buying and selling equities. In low-volume trading, even small trades can cause volatility to spike.

In these types of environments, covered calls and other volatility-selling strategies become more popular to traders seeking additional income, while those looking to protect long equity positions are buying volatility to hedge against the risks that can come with low volume.

Option traders who have a better grasp of the markets can structure positions that take advantage of a summer lull while limiting potential downside. Covered calls may be the most popular trade in the option arsenal, but they can carry substantial risk if the market falls out of bed. Calendar spreads and butterflies may be better methods of milking markets that are moving sideways.

The calendar spread involves selling a call (or a put) and buying one at the same strike in a farther-out month. The amount spent on the spread is the most that can be lost, up until the first expiration and excluding VIX options. And the spread takes a maximum profit if the underlying is around the strike when the that first expiration approaches.

The strategy is designed to take advantage of range-bound trading and the increased time decay of options closer to expiration. One note of caution is that you should be careful how far apart the two expirations are because the greater the difference, the greater the risk. Calendars can also be used directionally with an out-of-the-money strike.

For example, in early July we suggested the possibility of a SPY 133 calendar. At that time the trade would have involved buying the September 133 puts for $3.60 and selling the August 133 puts for $2.40. The spread cost $1.20, which was the most that could be lost.

If the SPY is around $133 when that August expiration rolls around, those calls will have lost most of their value, while the September calls will still have decayed at a slower rate. The trade will have losses if the SPY rises--or falls--by too much.

The calendar spread is one way to trade during the slow summer months if one thinks that equities will remain range-bound and sluggish. It can also be used as a relatively low-cost directional bet that can still profits from the time decay of options.