Over the last couple of months, the Cisco Systems, Inc. (NASDAQ:CSCO) stock has been trading in a tight $15 to $17 window. I think that the stock will remain range bound for the next couple months. This pattern presents an interesting opportunity to use an options strategy known as the short strangle. This strategy involves selling a put at a lower strike price and selling a call at a higher strike price. We are betting that the stock stays between $15 and $17 at expiration. Take a look at the trading range below:
We set our strikes based on the trading range of $15 to $17, where we sell the put at the lower end of the range ($15) and sell the call at the higher end (17$). Options are great tools when used wisely. They allow you to customize the risk vs. reward profile of your trade and target specific outcomes. For this trade, I am using the September expiration options. At the close of trading on Friday August 3rd, call options with a $17 strike could be sold for $0.45 and puts options with a $15 strike could be sold for $0.26.
Best Case and Worst Case Outcomes
It is always good to know the risk before you enter into a trade. The maximum profit in this trade is $0.45 + $0.26 = $0.71 if the stock stays between $15 and $17 on September 21st. The stock is currently trading at $16.35 per share, so the profit would represent over 4% of the stock price. Not bad for less than 2 months time if you annualize the rate of return! Based on the trading range I'd say this is a likely scenario.
However, we also need to consider the risk of the trade if it goes wrong. The potential loss is actually unlimited as we are liable for the difference between stock price and 17 if the stock is above $17 at expiration. Below 15, we are also liable for the difference between the stock price and 15 if the stock is bellow $15 at expiration. However, our loss is not unlimited in this downward scenario as the stock cannot go below zero.
What Will Probably Happen?
If the options are priced fairly, the stock should close at one of our breakeven points of $17.71 or $14.29. But the whole point of trying to beat the market is to have an opinion that is different from the market. In this case, it is that I don't think the options are priced fairly - I think they are overpriced. That's why I'm selling them.
In addition to the chart pattern, there are other reasons to believe that the stock will not move very much. Cisco has been a favorite stock of mine for years because of its stability. It has stable cash flows and an easy-to-understand business model. The company also began paying a dividend about a year ago, which generally adds to a stock's price stability. Overall, it's a predictable cash cow. However, it has fallen out of favor with most institutional money managers, and as a result, the stock has not been doing much of anything.
Reading the chart for CSCO seems to indicate that the stock is range bound. If you think that CSCO may stay in a tight trading range over the next couple months, you may want to consider the short strange options strategy. This provides for a potential profit of $0.71 (4% of the stock price) if the stock stays between $15 and $17 if you use the options expiring on September 21st.
Disclosure: I am long CSCO.