A Trader's Guide To Strangling The Market

Includes: CAT, VIXM
by: optionMONSTER

Are you annoyed at all the ups and downs in the market? Frustrated with the eurozone debt situation?

Well, you may not be able to wring the necks of European politicians, but can still strangle this market. And that's what we're going to look at today: How can you squeeze dollars from this bothersome soap opera across the pond?

Those of you who know about options may realize I'm talking about a common strategy known as a strangle, which involves selling both calls and puts. It's used to take advantage of high volatility, which jacks up option premiums. It makes a lot of sense given the recent pop in the VIX.

But I am going to add an element to the trade. Instead of simply selling options, I suggest that you use the trade as a hedge on long shares.

Let's consider Caterpillar (NYSE:CAT) as a case study, realizing that it could be applied to many other names in the current market. Its revenue has been strong, and there seems to be a secular trend underway in favor of heavy machinery. (See my recent mention of Terex and CNH Global, which both beat expectations as predicted.)

But CAT has already made a big move and is now pushing against downward-sloping 100- and 200-day moving averages. I want to be bullish in the long haul, but who knows what it could do in the near term?

One solution is to buy shares and write a strangle as protection. Example: Buy 100 shares for $93.94, then sell 1 December 85 put for $2.39 and 1 December 95 call for $4.75. That's a credit of $7.14, which reduces your cost basis in the stock down to $86.80.

There are three potential outcomes:

  1. CAT rallies above $95 by expiration and you have to sell shares for that price, resulting in a profit of more than 9 percent.
  2. CAT falls down below $85, and you're forced to buy an additional 100 shares for that price. But, when you consider the credit earned, your entry price on that second amount of stock would be $77.86.
  3. CAT stays between $85 and $95, and you keep you initial 100 shares. You can then exit the position for a small profit, or sell another strangle to remain in the position, lowering your cost basis further.

Granted, there is some risk to this trade. Say CAT really takes a dive. You're then on the hook for the short puts, which will obligate you to buy more shares at $85. So, it only makes sense to go halfway off the bat. If you're willing to own 200 CAT shares, then start with 100 shares. If it does drop down to $85, you'll be assigned the next 100 shares.

The advantage of this strategy is that it saves you from having to pick an entry price. Is CAT good here just below $94, or should you wait for a pullback to $88? Should you look for support at the 10-day moving average or the 20-day? You can drive yourself mad trying to answer those questions. Using the strangle makes them all go away.

The result is that you're more likely to earn some profit and are less at risk of short-term gyrations. It's a way to choke up on the bat and swing for singles, trading the market you have--not the market you wish you had. As I have said before, we're in the final years of the post-2000 bear. Not too long in the future there will be a time when you can load up and let 'er rip. But that's not today.

Finally, a word about volatility, which is key to this trade. Those of you who study the VIX will notice that its initial spike during times of panic is usually its highest. Volatility normally explodes higher, remains elevated for a while, makes a lower high, and then declines.

This is not always true but is generally the case, as seen in such periods as October-November 1992, March-April 1995, October-November 1997, July-October 2002, October-November 2008, and May-July 2010.

If the latest pop in the VIX follows the same pattern, now may be an ideal time to sell volatility. As I stated previously, the global economy simply refuses to be derailed by Greece and Italy.

In the intermediate term, that will probably trump the crisis in Europe and support stocks. There can still be ups and downs, and a trade like a strangle-protected long can smooth the ride.