Many "experts" will tell you that Apple Inc. (AAPL) will reach $500.00/share at some point in 2012 or Google (GOOG) will surpass $725.00/share. The truth is they don't know any more than you do. Nobody does. If the markets rise in 2012, AAPL can go to $500. If they fall, it can go to $300.
In this article, I'm not going to "predict" the prices of individual stocks and indexes. I simply don't know what the markets are going to do in 2012. Instead, I would like to present some simple strategies to make money in any market. If you want to stop guessing where the markets or individual stocks will go, those strategies might be for you.
Those who follow me on Seeking Alpha or just read my articles already know that pre-earnings strangles and index Iron Condors (IC) are among my favorite strategies. I described the first one here and the second one here. This is not a coincidence. Those two strategies have strong negative correlation and provide very good protection against any market surprises.
As a reminder, the first strategy involves buying a strangle a few days before earnings and selling it just before earnings are announced (or as soon as the trade produces a sufficient profit). The idea is to take advantage of the rising Implied Volatility (IV) of the options before the earnings. In general, I look for companies having a history of big post-earnings price moves. Those big moves will cause the IV to spike before earnings. For some higher priced stocks, I might sell further Out of The Money (OTM) strangle, converting it to a Reverse Iron Condor, like the one I used in the FedEx (NYSE:FDX) trade. The P/L graph of the strangle looks like this:
(Click charts to expand)
The second strategy (Iron Condor) involves selling a lower strike out-of-the-money put, buying an even lower strike out-of-the-money put, selling a higher strike out-of-the-money call and buying another even higher strike out-of-the-money call. I implement this strategy on broad market indexes like the Russell 2000 Index (RUT) or Nasdaq 100 index (NDX). The strategy makes money if the underlying index remains between the short strikes during the life of the trade. The P/L graph looks like this:
When I say that the strategies are negatively correlated, what does it mean?
The first strategy (strangle) is theta negative and vega positive. That means that it is losing money due to time decay of the options but gaining from increasing IV. The second strategy (IC) is theta positive and vega negative - it is making money due to time decay of the options and losing money if the IV increases. As we can clearly see from the P/L graphs, they look exactly the opposite but the strangles have unlimited profit potential and the ICs have limited loss due to its hedged structure.
So how does it help us? When the markets are moving sideways, the IC will make good money, usually in the 20-25% range, sometimes even more. The strangles will still gain from the increasing IV. When the markets move, the IC might end up a small loser (good risk management is critical for this strategy in order to minimize losses) but the strangles will make good money. For example, in August 2011 when the markets collapsed, all my strangles doubled in just 2-3 days due to sharp stock moves and jump in IV.
Let's take a look how a hypothetical portfolio might look. I'm assuming we are in the busiest period of the earnings cycle when most of the big names report.
- 20% in the Russell 2000 Index or the Russell 2000 Index ETF (NYSEARCA:IWM) Iron Condor
- 20% in the S&P 500 index or S&P 500 index ETF (NYSEARCA:SPY) Iron Condor or Butterfly
- 8% in Apple strangle
- 8% in Goggle Reverse Iron Condor
- 8% in Amazon (AMZN) Reverse Iron Condor
- 8% in Netflix (NFLX) strangle
- 8% in Wynn Resorts (NASDAQ:WYNN) strangle
- 20% in cash
The portfolio is non-directional and delta neutral. The goal is to generate 8-10% return per month on the whole portfolio. If you think this goal is too aggressive, look at some of the trades I shared on SA using this strategy:
- RUT Iron Condor gained 51% in 24 days.
- SPY Bufferfly gained 65% in 13 days.
- FedEx (FDX) Reverse Iron Condor gained 27% in 14 days.
- Nike (NYSE:NKE) strangle gained 7% in 5 days.
I'm not going to guarantee like some other authors do that this portfolio is going to double by January 31, 2012. This is arrogant and irresponsible. If I could double my money every month, I would be richer than Warren Buffett in no time. But I do think that those strategies can bring a steady growth to any account, no matter what the markets do. And the best part is - you don't have to predict the market direction anymore.
Disclosure: I have the RUT Iron Condor position and plan to place the GOOG and AAPL trades within one week.