In this article we take a look at the risks and rewards of sideways and downwards moves.
In the previous article we discussed some of the risks and rewards of looking for an upwards move. Today we are going to very briefly take a look at looking for a downwards move, and also begin to take a look at the risks and rewards of a sideways move.
Every position that is entered is based on expectations of where the price will be at some point in the future. This future could be mere minutes away for a day trader all the way up to many months away for a very long term investor.
From where ever the price is currently at, you can draw these 3 lines on the chart and say it will do one of the 3.
Whether you use fundamental analysis, technical analysis, or just flip a coin, when you enter a position you are entering one expecting the price to move in one of these 3 directions.
For Scenario # 3 we would be expecting for the price to fall, to begin a downwards move. This is basically the same thing as we saw in the first scenario, but instead of buying stock to go long, you would sell SHORT stock. And instead of buying calls, you would look at buying puts. When you short stock, it must be done in in a margin account, and for individual stocks you also have the uptick rule to contend with. There is also the added risk with a short position, is that the price can go up infinitely. When you buy stock, the risk is that it goes to 0, but with a short, there is no ceiling, so you can have unlimited risk. The risks and rewards of buying puts are the same as buying calls, if the price does not move down, then you have the risk of losing time value in a sideways move, and you have the risk of the price moving up. Because this is so similar to the “long” article I will not go into further detail and bore you by saying the same thing but swapping calls for puts, short for long, and down for up.
This leaves us with scenario #2, where we would be expecting the price to move sideways, to remain in a trading range. This can better be characterized by saying the expectations for this scenario is for the price to NOT move up, and for it to NOT move down!
The sideways move is the bane to a stock trader. The price is not moving up to where a long position can profit, nor is it moving down where a short position is making money. This represents “dead” money, where a simple bank account out performs the trading account. The way to profit from a sideways move is with the selling of time value in options. The first aspect of a sideways move that will have to be considered is time. When you are dealing with options, time is one of the most important factors, and for a sideways move you are taking advantage of the erosion in the time value of the options that you sell, with the intent of the contract expiring worthless so you can keep all of the premium that you sold.
There are different types of sideways moves that we need to take a look at.
First we have a sideways trading range. On this chart the price is oscillating up and down between these 2 white lines.
One options strategy that could be used would be to sell call spreads. The first would be to sell the call vertical spread that corresponds to the level of the top white line. To do this you sell the lower strike call and buy the strike just above this level. And at the bottom line you could sell the put vertical spread where you sell the put at the strike where the bottom line is at, while buying the put at the next lower strike.
This would effectively create an iron condor, where both sides of it would profit should the price remain within these 2 white lines until the options expire.
This chart is showing a sideways move at the top of the preceding upwards move. On this chart the sideways move is in a very tight range, where it is up one candle and down the next.
If you believe that this represents that a top is forming, that would mean that the price is not going to move to new highs. The strategy here would be to sell a call vertical spread. You would sell the call at the strike at the top white line and buy the call one strike above it. This way while the price remains at or below that top white line you would keep the premium that you sold. The only way you lose on this position would be for the price to move up above that top white line and remain above it when the contract expires.
If you felt that the sideways move was at a bottom, then you could sell the put vertical spread, and you are looking for the price to remain at or above the strike price of the put you sold.
The advantage to selling premium is that you have 2 ways for the position to make money. The price can move sideways, or move in your favor. The only way to lose money on the position is for the price of the stock to move against you and remain beyond the strike you sold at expiration.
The reason you sell a vertical is that the strike you buy is the “stop loss”, the protection of the position. Your risk will be the difference of the strike you sold to the strike you bought.
In these articles we have discussed some of the risks and rewards of different positions that can be taken, from buying or shorting shares of stock, to buying and selling options and vertical spreads. I have not gone into detail on the options, as the purpose of these first few articles is to introduce the ideas of how these different positions work. It will be in future articles where we will start to get into more detail on how and when you would want to consider using the different strategies.
The next article will be on how we can get the expectation of what the price will do from a given point. Yes you can draw those 3 lines (up, sideways & down) from any given point, but it helps when you can make the determination as to which one is most likely to happen, so what we need to review is how to determine which direction is showing the best potential.