I've been completely unable to ignore the minor correction going on in my portfolio as we lead up to the elections next week. I can't say that it bothers me too much as this is just a part of the normal cost of business for my style of investing. There are ups and downs, and as long as I have more ups than downs I can keep on smiling. It's been a good run since 2008. However, I have also noticed that some of my core holdings have pulled back to levels of support which make a neutral short-term options strategy a potential play.
As we have a significant amount of economic uncertainty in everyone's minds (ongoing Eurozone woes, impending fiscal cliff, complete economic obliteration, or whatever else you may want to call it), I don't really expect stocks to have much of a breakout until we can determine expectations on future fiscal policy after we know who is elected and see what happens with the federal budget in the new session of Congress. This only seems reasonable. By no means guaranteed, but we consider the facts as we know them and make an educated decision in moving money around.
We additionally know that we can make money in any type of market -- up, down, or sideways. The up and down markets are much more straightforward and easier to manage, but it is these sideways times that make it tricky and we have to get a little more creative. One method that will be hailed by many of our Seeking Alpha members will be remaining invested in quality companies paying a dividend. The dividend will adjust your overall return by the rate of the dividend, by either adding to the small positive return you see or else counteracting some of the possible loss. Another method which may work for you given the known short time period before the election is to take advantage of a quality stock trading within a narrow range and execute a short-term neutral options strategy in an attempt to profit off the sideways action in the coming weeks.
In this example I will use SPY as a basis, but there are several solid stocks that could meet this criteria. Take a look at GE (NYSE:GE), Intel (NASDAQ:INTC) or Caterpillar (NYSE:CAT). I am sure someone will make the argument for Apple (AAPL), and that may be a choice for you. I will state up front though that the primary problem with this type of trade as an individual investor is that your brokerage is the one who really makes the money. You assume all the risk while the brokerage takes a hefty chunk out of your potential profits unless you have the cash to make a large trade. That of course will drive up your risk. Regardless, on to the numbers...
We all know that past performance is no guarantee of blah, blah, blah... Got it. But Looking at the 3-month chart gives a current range of generally $137 to $146. If we believe that the market will stay in a sideways funk for the short-term, we can establish a near mid-point for this range of $142. This particular index went on a nice 6.5% run between August and mid-October before dropping back just under 3% to current levels. With the uncertainty of the elections and the damage from Hurricane Sandy, let's see what we can work on with a butterfly spread.
Beginning with the shortest term trade possible, November 2 is only two days away. This trade consists of one long $138 call, two short $142 calls, and one long $146 call. The cash outlay is $202 per spread, with a maximum profit of $198 if the price is exactly $142 as of expiration. The position is profitable anywhere between $140.02 and $143.98, although you will need to adjust this range and maximum profit to account for fees on both sides of the transaction. With no fees, your profit could range as high as nearly 100%, but this is not the case. With something near standard fees, you would realistically see maximum profit somewhere around $140, and the profitable range squeeze by about 60 cents on each side. I don't think I like my odds as much anymore, although this trade has the "advantage" of expiring before the elections.
Let's try again with a longer time horizon to see what happens...
A December 22 butterfly spread would consist of the same legs, but the cost is quite different. The cash outlay for this spread is only $87 before fees with a maximum profit of $313. The profitable range on this trade becomes $138.87 to $145.13, although again we need to reduce all the numbers in accordance with fees (to include maximum loss). Our realistically profitable range is somewhere around $139.50 to $144.50, and our maximum profit could be in the area of $250 with a maximum loss around $150.
These numbers look a lot more tempting, however we need to remember that a LOT can happen between now and the end of December, and the potential for profit on this trade requires that either nothing happens to move the market, or that the things that do happen balance each other out. Anyone could win this election. Congress could take the pansy way out and just repeal the law they passed which requires them to do their job. Impending tax changes could encourage investors to dump stocks before the end of the tax year. Global warming could cause a superstorm to dump 3 feet of snow across the Mid-Atlantic. China could send a notice of foreclosure to the White House. The point is that even betting on nothing is a risky proposition, especially over a longer time horizon.
The numbers beyond December 22 do not change significantly relative to the increased risk associated with a longer timeline. You would need to try adjusting the positions of your trades to create a wider profit band.
Options can be a useful tool in managing your portfolio overall, but often the potential profits are not worth the increased workload and headache, especially after your broker gets the required bite. A small change in the underlying price can quickly wipe out your entire investment, or correspondingly result in a huge profit if you are positioned in that manner.
So is this type of trade for everyone? Absolutely not. Would I recommend this to my friends? No, because I value their friendship. Do I make this type of trade myself? Sometimes, but only with limited portions of my portfolio and as part of a calculated risk. Will I make this trade today? Maybe. I have a few hours left to figure it out.
Disclosure: I am long GE, INTC, CAT, AAPL. 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.