After hitting all-time highs near 1576, the S&P 500 fell sharply to near 1548 on Thursday, October 11 2007. There are still many things weighing in on the market that should keep it in check before the end of the year. A good way to position yourself going into the end of the year would be to use options, and I recommend selling strangles.
Selling a strangle involves selling a call option and selling a put option at a lower strike price. A position like this will make money if the market stays within your bracketed range of strike prices. In my opinion, the best way to position yourself going into the end of this year is to sell a call with a strike price of 1600 and sell a put with at a strike of 1500. The premium that you can receive for this is approximately 50-52 points. The expiration on these options is December 21, 2007. If the December S&P 500 futures stay between 1500 and 1600 before December 21, this position will be profitable.
The December S&P 500 futures contract has traded above 1571 on Thursday, October 11. Despite the fact that the market has sharply rallied, I think there is still a lot of bearish influence on this market that could surface. There are fundamental and technical factors that should keep this market between 1500 and 1600.
On the fundamental side, we have seen strong employment numbers. Many investors are watching inflation very carefully. This can be seen from the rise in gold prices. Gold for December delivery traded above $756 on Thursday, up more than $10 as of this writing. Gold is considered a hedge against inflation. Friday’s September Producer Price Index, a measure of inflation at the wholesale level, will be a number to watch for more indication on where inflation is heading.
On the technical side a lot of indicators and studies have shown positive momentum as we’ve seen in this uptrend over the last several weeks. However, I’m starting to get technical indications that things are getting into overbought territory.
If you look at the December S&P 500 chart below you’ll see an 8-day moving average. As you can see here, for the last several weeks since the Federal Reserve made their decision to cute rates on September 18, this market has been pushed higher. The market has done a good job of maintaining its closes above the 8-day moving average. To me, that is still a positive sign that the short term trend is pushing higher.
With that being said, I don’t think this market is going to go up sharply and stage any strong rallies into the year end. I think we still have to look at some of the bigger picture fundamentals and what is still weighing on the market. A few months ago, there was a lot of talk about the housing market and the sub-prime issues. This problem has not yet been solved and is still affecting us.
Aside from that, a slowing of business activity is becoming more widespread. In the auto sector, we are starting to see the big auto makers reporting softer sales. They are also continuing to lose market share. The manufacturing and non-manufacturing sectors are also seeing slower rates of growth. All these issues are keeping this market in check, despite the recent run to the upside.
On October 31, U.S. third quarter Gross Domestic Product data will be released. I think we’ll be lucky to see a 2 percent GDP increase. That should also keep this market in check. Stay tuned.
S&P 500 Strangle Strategy
Whether you’re an experienced options trader or not, selling strangles on the S&P 500 futures are a good strategy to look at. In my opinion, it is best suited to take advantage of the S&P 500 market as we head into the new year.
Let’s cover the specifics of this strategy. Once again, we would sell a call at 1600 and sell a put at 1500 for the December E-mini S&P futures contract. When you have an options transaction, there is a buyer and a seller. The buyer pays the premium. As a seller of both the call and the put you are collecting a premium from the buyer. The concept behind selling a strangle is that you want to see the market in a range (between 1500 and 1600) before expiration (December 21).
For simplicity, let’s assume we collect 50 points in premium. If the option purchaser pays you, the seller, 50 points on the E-mini S&P 500, each contract point is $50, so we get $2,500 ($50 x 50 points) in premium from the purchaser, excluding commission cost. The option buyer is paying $2,500 to take the other side of that contract, excluding commissions.
Looking back at the technicals in this market, I believe 1500 is a very psychological number. If you look at the 50-day moving average, it is currently coming in at around 1500 now. In the chart above, you’ll notice a sharp decline in August. We had several attempts to push this market up through the 1500 level. After several failed attempts to break the 1500 level, the market finally did after the Federal Reserve cut rates on September 18. This has helped us to keep the levels we are at right now. Therefore, I think 1500 is a good floor for the market right now and a good strike price to be selling a put.
On the upside, 1600 is another psychological level for this market. I don’t see the market, for some the fundamental reasons I mentioned, going above this level before the end of the year. Don’t get me wrong, I know there are a lot of bullish people out there. I’m also bullish on this market long term, but I’m also a realist.
If we receive 50 points in premium in selling the strangle, where are our breakeven points? To figure this out on the upside, we would add the 50 points we received in premium to the call’s strike price of 1600. That gives us 1650 as our first breakeven level. If the market trades above 1650 on expiration, this trade will lose money. Likewise, we would subtract 50 points from the 1500 strike price of the put. That gives us 1450. Therefore, if this market trades above 1650 or below 1450 on the expiration date, the position will lose money. If we trade between 1450 and 1650, this trade will make money. Of course, you will also incur transaction costs which should be taken into account.
Keep in mind that this isn’t a trade that you just set and forget. This is a trade that you monitor on a daily basis. This is what I help my clients do on a day-to-day basis at our professional trading desk at Lind Plus. The nice thing about selling a strangle, in contrast to day trading or swing trading is that the daily market noise does not necessarily scare us out of the market. You are not choosing direction on a daily basis.
Concept of Time Decay
A short strangle position benefits from a concept in option trading called time-decay. In out-of-the-money options like the ones we mentioned, all the premium here is considered time value. The important thing to understand is that as an options seller you are collecting the premium. Every additional day that goes by contributes to more time decays in those options which make them more valuable to the option seller.
Statistically speaking, many studies have been done on options. Approximately 80 percent of all options that are purchased and held to expiration end up expiring worthless. So as the seller of an option, you collect the premium. There is a statistical probability of you being able to keep that premium, but there are also risks involved. Selling an option involves unlimited risk, like a futures contract. This strategy is not suitable for all traders. For those that are willing to assume that risk and get away from choosing the daily direction of the market, this presents itself as a viable strategy.
I believe the seriousness of the sub-prime issue, along with other fundamental issues will keep this market in check. In 2004, 33 percent of all mortgages were adjustable rate mortgages (ARMs). This year, approximately $400 billion of these mortgages are resetting to higher interest rates. Next year, it is expected that $1 trillion in mortgages will be resetting. That’s two and a half times more than what is resetting now. This is definitely a serious issue that has not gone away.
We can expect to see not only people with poor credit having trouble paying there mortgage, but also those with decent credit have difficulty. Thus, I think the foreclosure rate is going to remain high and I think housing is going to continue to be a drag on the economy for the foreseeable future.
Michael Sabo is a Senior Market Strategist with Lind Plus. He can be reached at 800-798-7671 or via email at msabo@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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