Plenty of investors hold shares that hardly seem to move. I’ve held them myself. The stability is relaxing, the lack of profit punch frustrating. And holding a stock that’s range bound, or trading through a period of consolidation, harms your comparative return during that stagnant period. It can also tempt you to sell when you don’t really want to: boredom trades are usually wrong.
For periods like this, however, there are a few options strategies that can keep your attention focused and keep your gains rolling in. Your profit doesn’t have to be strangled short of optimum if you use a short strangle strategy.
For a market where price volatility has collapsed or when you believe your stock is going to trade range bound for a time, working a short strangle option strategy allows you to make a profit that otherwise would be non-existent.
Essentially this is a strategy that allows you to top and tail the range that you expect your stock to trade in, using a call option and a put option, and receiving a payment for doing so. To implement the short strangle, you’ll be giving someone the option to buy your stock from you at the top of the expected range (or just above it) whilst at the same time giving someone the option to sell stock to you at the bottom of the expected range (or just below it).
You’ll be selling a call at the top end, and selling a put at the bottom end.
Example: Canadian Utilities (TSX: CU)
By way of an example, let’s consider Canadian Utilities (TSX: CU). The stock has traded in the range of $59 to $72 during the last 11 months. That’s a pretty healthy range, but during those 11 months the stock traded the first six months at $59 to $64, and then since then has traded between $65 and $72. It’s been range bound for long periods of time, only changing that range when the shares finally broke up through a level of resistance and after a long period of consolidation.
With the latest move below $70, you conduct your research, looking at anything on the horizon that might be expected to move the share price. Having completed this, you believe that Canadian Utilities stock will continue to trade between $65 and $70 during the next couple of months, through to the expiry of the October options. So you look at the options expiring in October and discover that you can sell a put with a strike price of $64 at the bid price of $0.55, and sell a call with a strike price of $70 at the bid price of $1.15.
You sell both options, the call at the high end and the put at the low end of your expected trading range. And you receive total option premium of $1.70.
So long as the share price remains within the identified trading range through to expiry, then the option premium you were paid will be your profit. That’s a return of 2.5% on the value of the shares you hold in a couple of months.
But, before we get too hasty and too bold, there is a risk. If the stock price moves down below the bottom of the range, you risk being exercised against and being forced to buy the shares applicable on the put option. So, your profit begins to erode if the price falls below $64. But don’t forget you’ve got the option premium as ‘insurance’, so you won’t move to a loss until the stock falls below $62.30 ($64 – $1.70 option premium).
Similarly, if the share price moves up through the price of the call option you sold, then your profit will start dwindling. But don’t forget that option premium: for you to move to a loss, then the share price will have to move above $71.70 ($70 + $1.70 option premium).
As with any strategy, you’ll need to monitor and manage your position. And that’s a whole lot more interesting than watching your stock do nothing. And just imagine if you repeated the operation every couple of months, netting 2.5% each time. That’s a cool 15% return on a stock that didn’t move.
Some investors, when they are working a strategy like this, make a table of profit and breakeven points so they remain focused on these while the strategy is live.
Of course, you might have commissions and margins to lodge, so you will need to allow for this in your calculations. But you’ll also have use of the money received from the option premium from the day you receive it.
Remember, this sort of profit potential doesn’t come without risk. A large move to the upside or the downside could result in a large loss. But that’s why you manage the position, prepared to take remedial action if needed and at the same time plugging that profit gap.
Remember also that the example above is exactly that, an example and not advice. I haven’t done the research that I would do if I held the Canadian Utilities stock, but have only used the 52 week chart as a starting point. You should always conduct your own research before committing to any trade or options strategy.