Global markets appear to have hit a ceiling on the upside. And with third-quarter earnings expected to reinforce the position that economic growth is slowing, the markets may well remain in neutral through the end of the year – or perhaps longer if U.S. tax rates increase in early 2013.
On the other hand, with central banks continuing to add liquidity, there is a strong case to be made that downside risk is limited. There also is the possibility that the bulls could gain momentum if the U.S. government takes serious action on its fiscal cliff issue.
The eurozone is another matter. You can expect news from that sphere to take centre stage periodically, and markets will react quickly and negatively. The eurozone has dug itself into such a deep hole that most observers believe nothing positive will happen until well into 2014. All told, investors are locked in a bull/bear tug of war that is likely to result in an ever-widening trading range.
Options traders can play this situation a couple of ways. The first is a bear call spread, in which you sell calls slightly above current levels and hedge against an upside surprise by purchasing calls at a higher strike price. The second approach is the “iron condor,” which is simply a bear call spread combined with a bull put spread. The iron condor works best if the market trades within a range bounded by the two short options.
The bear call spread is the appropriate strategy if you are leaning to the bear side of the debate. The bear call spread offers a limited-risk way to profit from a scenario in which the market declines or stays the same. And the possibility of a margin call is negligible.
Consider options on the S&P 500 composite index (symbol: SPX), which recently closed at 1440. A bear call spread could be initiated with the sale of the SPX December 1450 calls at US$29.50 combined with the simultaneous purchase of the SPX December 1500 calls at US$10. The net credit in this position is US$19.50 (US$1,950 per spread) – the difference between the money received from the sale of the SPX December 1450 calls vs the cost of buying the SPX December 1500 calls. The maximum risk is the difference between the 1450 and 1500 strike prices (US$5,000 per contract) less the net credit received, or US$3,050.
The bear call spread profits if the market declines or remains where it is. If SPX is below 1450 at the December expiration, both options will expire worthless and your client pockets the net premium received of US$19.50.
The iron condor adds another wing to this trade. In this case, you also would initiate a bull put spread, which involves selling the SPX December 1400 puts (at US$25.50) and simultaneously purchasing the SPX December 1350 puts (US$15), for a net credit of US$10.50 (US$1,050 per spread).
As you are incorporating two spreads, the risk is still limited to the difference in the strike prices (US$5,000 per contract) less the two net credits received (US$1,050 + US$1,950 = US$3,000), or US$2,000 per iron condor. The risk is the same as the bear call spread because only one spread is at risk at any point in time.
The iron condor earns the maximum profit if SPX closes between 1400 and 1450. In that case, all the options would expire worthless and your client would retain the net credit.
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