This Play Could Gift Traders a 43% Return Before Christmas

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There seems to be widespread agreement that tax rates affect stock prices. Unfortunately, for traders looking for an edge in the stockmarket , there is no evidence showing what that effect is. There have beenbull markets when tax rates fell, and there are examples of bull markets that survived tax increases. And traders have enduredbear markets whentaxes increased, as well as when they decreased.

This time aroundwill be the same, and whether tax rates increase or decrease, stock prices will continue to move up and down. If a deal is announced, we are likely to see market volatility. Without a deal, we are also likely to see volatility as traders react to a breakdown in negotiations. Rather than trying to forecast the direction of the price move, we can open a trade that will benefit from an increase in volatility whether prices rise or fall.

An options trade known as a straddle uses an equal number of put andcall contracts on a stock orETF . The options have the sameexpiration date andstrike price . With a straddle, a trader is trying toprofit from a large price move, regardless of the direction.

A straddle on ProShares Ultra S&P500 ( SSO ) offers a way to benefit from the expected move. SSO is trading at about $59. Calls with a strike price of $59 are trading at $1.58 and puts at that strike price are $1.48. The combined cost of the position consisting of one call and one put will be about $3.06.

Because SSO is a leveraged ETF, the fund's managers rebalance its holdings daily. That means the fund will not precisely match the movements of the S&P 500 over the long term. However, the trend in the price will generally match theindex during a period of several weeks. Since the options expire at the close of trading on Dec. 21, the daily rebalancings should not present a significant problem.

If SSO moves up by about 5%, this trade should be profitable. The call should be worth at least $3.06 if SSO reaches $62.06 (a 5% gain), while the put could be nearly worthless at that point. Because SSO is leveraged, a 2.5% change in the S&P 500 should result in a move of that size in the ETF.

On the downside, if SSO falls to $55.94 (a 5% loss), the put should be worth at least $3.06 and the call would be worthless, and the trade would be profitable if SSO moves lower than that. This could be achieved with a 2.5% decline in the S&P 500.

The chart below shows that SSO has had one-week moves of $5 or more when market volatility spikes. Given that there are three weeks before expiration and a high probability of a news-driven move in the stock market during that time, I believe it is likely we will see a price move of that size or more soon.

Theaverage true range ( ATR ) shown in the chart below has been in a range of relatively low values and spikes in theATR , seen when prices make a large move, have not occurred for more than a year, so SSO could be due.

This is a highly speculative trade, but the risk is limited to the amount paid for the options. Any loss on the trade is likely to be less than the amount paid, and there is a high potential that traders will enjoy a large reward from this trade if there is a large move in the market.

Action to Take --> Buy an equal number of SSO Dec 59 Calls and SSO Dec 59 Puts for a combined cost of $3.50 or less. Do not use a stop-loss (one of the options should have some value at expiration, which should reduce the amount of a potential loss). Setprice target at $5 for a potential 43% gain in three weeks.

This article originally appeared on TradingAuthority.com:
This Play Could Gift Traders a 43% Return Before Christmas



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.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , ETFs

Referenced Stocks: ATR , SSO

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