The Neutral Market Strategy

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Sara Smith
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The Neutral Market Strategy GOAL To make a profit selling options in a sideways-moving market. SUMMARY Experts estimate that markets typically trend roughly 30% of the time.

1 The Neutral Market Strategy GOAL To make a profit selling options in a sideways-moving market. SUMMARY Experts estimate that markets typically trend roughly 30% of the time. The remaining 70% of the time they are in consolidation mode. Virtually all the patterns we trade in the Greatest Business on Earth are consolidation patterns that form in the middle of trending markets. We take advantage of a temporary lull in price activity to more safely step into a market that s generally moving up or down. But sometimes a market gets stuck in one of these sideways patterns for a prolonged period of time. Fortunately, we don t have to wait months, maybe even years, for a breakout that signals the continuation of the old trend or the beginning of a new one before we can make a profit in such a market. There is a strategy we can use to profit from long-term sideways price action. We call it the Neutral Market strategy, and we can use it to make a profit based on where a market doesn t go! This option-selling strategy has us selling far-out-of-the-money put and call options in the same contract month. If everything works as planned, both options expire worthless, allowing us to pocket the premium collected (less fees and commissions). CHAPTER ONE STEP-BY-STEP INSTRUCTIONS 1 Only initiate this strategy in markets that are moving sideways. This strategy DOES NOT WORK in clearly trending markets. For trending markets, refer to one of our other strategies. 2 Visually identify the price action on the chart to determine that the market is moving sideways and trading between distinct support and resistance levels. We call this a trading range (also sometimes known as a channel formation when it s narrow enough to be obvious on the chart). Although

there is no hard and fast rule about how long prices should maintain such a range before a trader would initiate this strategy, you might consider roughly two months as a minimum amount of time to

As of this writing (late June 2008), the September 2008 Canadian Dollar has been trading in a limited range since midnovember 2007. The range is defined by the high at 1.

Please note that a trading range this long is a rather extreme example. For the purposes of executing this strategy, a two-month trading range should be sufficient.

2 there is no hard and fast rule about how long prices should maintain such a range before a trader would initiate this strategy, you might consider roughly two months as a minimum amount of time to look for. Let s examine a sample chart to see what sideways action looks like. As of this writing (late June 2008), the September 2008 Canadian Dollar has been trading in a limited range since midnovember The range is defined by the high at (made on February 28, 2008) and the low at (made on January 22, 2008). Prices have not moved outside of this trading range for close to seven months. Please note that a trading range this long is a rather extreme example. For the purposes of executing this strategy, a two-month trading range should be sufficient. Since this wide trading range has been in effect for so long, it seems unlikely that prices will suddenly drop below or rise above any time soon. Using the Neutral Market strategy, we can simultaneously sell both a put option with a strike price near but below the strong level of support, and a call option with a strike price near but above the strong level of resistance. This would allow us to collect two premiums and generate income even though the Canadian Dollar is going nowhere. 3 Try to sell options with 70 days or less left before expiration. This assures the options will have enough time-value remaining so that the premiums you collect will be high enough to make the trade worthwhile, while at the same time allowing the time decay factor to work in your favor. Phone Toll-Free Fax The Greatest Business on EarthTM

3 4 Sell strike prices that are in the range of three to five strike prices from being at-the-money. 5 If initiating a Neutral Market strategy trade within the last 30 days prior to expiration, be sure the options being sold allow you to collect at least $275. This helps offset commissions and fees and still allows you to potentially profit from the transaction. CHAPTER TWO POSSIBLE EXIT STRATEGIES Because you re selling two options in this strategy it s important that you stay on top of the trade and are prepared to act quickly. If price is more important to you than time in exiting the market, use limit orders to liquidate your position. However, if time is more important to you than price, and you want to liquidate as quickly as possible, use a market order. In a Market That Continues Sideways Close out the trade and take profits when 80% of the available premium has been collected that is, you can purchase back your options for 20% or less of what you sold them for. This keeps you from risking the 80% that s been collected for the possibility of making that last 20% a common mistake made by many traders. In a Market That Begins Trending in Either Direction Close out both options if the trade loses $500 or if the underlying futures price moves to a point where one of the strikes sold is within one strike price of being at-the-money. CHAPTER THREE POSSIBLE EXIT STRATEGIES Let s say it s June 30, 2008 and we want to initiate a Neutral Market trade in the September Canadian Dollar. Checking on the going prices for options on that day, we see that we can sell the September call option for $220, and at the same time sell the September put option for $530. The total amount taken in would be $750: $220 + $530 = $750 (less fees and commissions). If prices stay above the lower strike price and below the higher strike price we ll have the opportunity to profit as much as $750 (or $600 if we use the exit strategy suggested above), and we don t even have to pick the direction that the market might move to!

5 Now we enter our new position into Trade Tracker. CHAPTER FOUR WHY THIS STRATEGY WORKS This strategy has the potential to work because the odds are on the option seller s side, especially with well out-of-the-money options. Most non-professional commodity traders do not sell (write) options. This is because they generally don t understand the concept of writing options, and they have likely heard that option writers can face the possibility of unlimited loss. They fear that a move against their position could not only mean a potential loss, but that it could actually ruin them. (In fact, this is extremely unlikely as long as the options sold are managed correctly. And remember, there is risk involved in any type of trading.) The professional trader, on the other hand, not only understands the odds, but also understands that the majority of general traders tend to buy options for the wrong reasons for the same reasons that lead many people to buy lottery tickets, hoping their cheap options will become huge winners! While this can happen from time to time, more often than not this is a lost-cause strategy used by greedy traders who hope to hit the lottery. Realizing that many uninformed traders buy options incorrectly, and that roughly 80% of these options will expire worthless, the pros take advantage of the situation. They are the biggest sellers of options, and they tend to profit a majority of the time. And time is on their side! Remember, an option is a wasting asset because an important part of its worth is its time value. The more time an option has until expiration, the more value it will have. The downside of this for the option buyer, or at least for those buyers who purchase options incorrectly, is that options lose some of their time value each day.

6 This is the reason why the Neutral Market Strategy works so well. With this strategy we sell out-ofthe-money options whose premiums primarily reflect time value. With each passing day, some of that time value is lost. What s more, as expiration nears, there is less and less chance that prices will hit and surpass either strike price and cause one of the options to begin gaining intrinsic value. This puts the option seller in a great position one that grows more and more secure as expiration day approaches. In effect, when we sell options we act much like a casino. We become the house, and collect a highpercentage return on each bet that is made. By selling well-out-of-the-money options in a stagnant market, the odds are extremely low that either of the strike prices we sell will be reached prior to expiration; the options are very likely to expire worthless. This is the beauty of selling out-of-the-money options in sideways markets. CHAPTER FIVE POSSIBLE ADVANTAGES OF THE STRATEGY 1 As mentioned earlier, according to many experts roughly 80% of all options expire worthless. Therefore, the Neutral Market strategy allows us to put the odds in our favor by selling out-of-themoney options in markets that are stuck in a trading range. If we implement the strategy correctly, the options we sell have a good chance of expiring worthless, allowing us to keep the premiums we collect. 2 This strategy provides an opportunity to make a profit even in markets that are stagnant. 3 The premiums you collect on the options you sell can help offset the margin requirements for those options.

7 CHAPTER SIX POSSIBLE DRAWBACKS Although the odds greatly favor the Neutral Market strategy being successful roughly 80% of the time (if implemented correctly), we must be aware that we are exposed to unlimited loss potential. We must be prepared to limit possible losses by being vigilant during this trade and using the exit strategy described above. And as always, good traders realize that not every trade will be a winner, so they always have an exit plan in place upon entering the market. Notice: Being a successful PAPER TRADER during one time period does not mean that you will make money when you actually invest during a later time period. Market conditions constantly change. When granting options, you may lose more than the funds you invested. Option spread strategies do not necessarily limit your risk of loss. Simulated performance results have certain inherent limitations and do not represent actual trading. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. This brief statement cannot disclose all the risks and other significant aspects of the commodity markets. You should carefully study commodity trading and consider whether such trading is suitable for you in light of your circumstances and financial resources before you trade. WARNING: FUTURES AND OPTIONS trading involves high risks and YOU can LOSE a lot of money.

Ratio Spread Strategy

Ratio Spread Strategy GOAL To defray part or all of the cost of trading a market with options by purchasing and selling options simultaneously in the same contract month. SUMMARY We purchase one option