Making Money in a Range-Bound Stock - Know Your Options

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Picking a stock that will trade within a broad range (either up, down, or sideways) to make money is easier than picking a stock that MUST go up or down in order to make money.

And the strategy to do that is an iron condor.

Whether you trade options regularly or not, you've probably heard of that strategy. Although, I'll bet the majority aren't quite sure what it is or how to set it up.

And we're going to clear that up today.


Definition

The iron condor is classified as a neutral strategy.

For instance, a bullish strategy, of course, means you're expecting the market to go up.

A bearish strategy has you expecting the market to go down.

But with this strategy, instead of picking a direction, you're defining a range. In other words, the price can go up by a certain amount, or down by a certain amount, or trade sideways. And any one of those three scenarios would result in the same exact maximum profitability.

This is considered a low risk, high probability trade.

The iron condor is usually put on as a credit, meaning you'll be a net collector of premium. And there are four parts to this trade.


Set up

The best way to explain it is to go over an actual trade I put on and I'm still holding. The one I'm going to illustrate was done on Deckers Outdoor ( DECK ). And I put this on back in January (Jan. 24th to be exact).

So here's what I did:

• Bought to open 1 June 2014 100.00 call at 2.47 (or $247 debit)
• Sold to open 1 June 2014 90.00 call at 4.32 (or $432 credit)

And...

• Sold to open 1 June 2014 60.00 put at 3.50 (or $350 credit)
• Bought to open 1 June 2014 50.00 put at 1.42 (or $142 debit)

Essentially, an Iron Condor is comprised of two credit spreads (one on the call side and one on the put side). We received a net credit of $185 on the call side, and we received a net credit of $208 on the put side, for a combined net credit of $393.

So the maximum profit on this kind of trade will always be your credit. And in this example, it's $393. And we'll see that as long as Deckers, at expiration (which is the third Friday in June), stays between $90 on the upside and $60 on the downside.

When we put this on, Deckers was trading smack dab in the middle of its range at $75. So that meant I had a cushion of $15 (or 20%) on either side of my entry. Since then, it's been all over the place within that broad range and it's currently trading just over $79, which is still pretty close to the middle of its range.

But in short, that meant it could go up 20%, or down 20%, or do nothing, and I'd still make the same amount of money.

That's pretty cool.

The maximum loss for this one would be $607. That would be seen if DECK closed above its outer strikes that I bought. In this case that means $100 on the upside and $50 on the downside.

However, condors move slowly. So you'd have to see a huge move to lose, and you'd have to ride that all the way to the end of expiration for that to happen.

The preferred way to trade it is to close it out once it goes through your inner strikes, regardless of how much time you have left. In fact, the more time you have left, the lesser your potential loss could be. So that's one way to minimize your risk.

The other tip is to consider pulling your profit if it gets too close to your inner strikes. You won't get all of your max gains. But, if you can get 50% or 60% or more on the trade (although, any kind of gain is better than a loss), that's not so bad, especially for a trade where you don't have to guess correctly on a direction, but instead just hit a broad range.


Gain and Loss Examples

For a winning example, let's say, at expiration, DECK closes up at $90, right at the top end of the range. That means:

• The 100 call that I paid $247 for would expire at $0 for a loss of -$247.
• The 90 call that I collected $432 for would also expire at $0, meaning I kept the entire $432.
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• So that's a net gain of $185.

On the put side:

• The 60 put that I collected $350 for would expire at $0, meaning I kept the entire $350.
• The 50 put that I paid $142 for would also expire at $0, for a loss of -$142.
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• So that's a net gain of $208.

• Add both sides up, and that's a $393 gain.

Whether it closed at the high end of that range, the low end of the range, or in the middle of the range, as long as it was within that range (between $60 and $90), the outcome would be the same.

But once you closed beyond the farther out strikes that you bought, then you've generated your maximum loss, which is the difference between the largest spread you have on and your maximum credit.

For this trade, the largest spread we have on either side is a $10 spread. (90 to 100 and 60 to 50). One $10 spread is equivalent to a $1,000 risk. Subtract your total credit and that's your max risk.

For a losing example, let's say at expiration, DECK closed lower at $49; just outside of the outer range. That means:

• The 100 call that I paid $247 for would expire at $0 for a loss of -$247.
• The 90 call that I collected $432 on would also expire at $0, meaning I kept the entire $432.
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• So that's a net gain of $185.

On the put side:

• The 60 put that I collected $350 on, is now in-the-money, and would be worth $1,100, meaning I lost -$750.
• The 50 put that I paid $142 for, is also in-the-money, but is only worth $100, which means I lost -$42.
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• So that's a net loss on this side of -$792.

• Total loss = -$607 ($185 gain less -$792 loss = -$607 net).

DECK could go to zero, or infinity, and the loss would still be limited, and the same.

So with this trade, you can place non-directional bets on a stock, and make money as long as it stays within your determined range.

To increase your probability of success, you want to establish a wide enough range. And since your profit is limited to the credit you collect, you want to put this on for as large of a credit as possible.

Here's a chart showing the range I want DECK to stay within by June 20th, which is the last trading day for June options:



Take note, in this example, the max gain is $392, while the max potential loss is $607. You can put on a condor for a 1 to 1 risk to reward ratio, or closer to a 1.5 to 1 risk to reward ratio, like this one.

The key is to get a big enough credit, while also keeping your range as large as possible. And you'll have to have a wide enough spread between your short and long strikes too, in order to collect enough money. That's one of the reasons why I will generally screen for higher-priced stocks since the options premiums are usually worth more.

Typically, when placing a directional trade, I'd like my potential reward to be 3 to 1 or better. But there's only one way to win on those kinds of trades.

In this instance, since there are 3 ways to profit (up, down or sideways), the lower reward to risk ratio is made up for the higher probability of winning. (Having three ways to win is better than having only one way to win.)

To put the odds in your favor even more, try and make sure your inner strikes are at least one full standard deviation away from the price. That means you'll have a 68% chance or more of seeing your stock trade within that profit range, which means a 68% chance or more of seeing your trade come out a winner.

Want to apply these and other winning option strategies to your trading? Then be sure to check to check out our Zacks Options Trader service.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.



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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Options

Referenced Stocks: DECK

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