Profit whether up or down

Bull or Bear, Profit Anyway
By Jeff Fischer
January 12, 2010 |

Following last year's record rebound, and awaiting economic data along with January and February earnings reports, everyone is on pins and needles waiting to see if stocks can continue their enthusiastic climb.

Will there be a recovery in the United States? Or will we just muddle along? We'd all like to see a recovery, but that's far from assured. And even if we enjoy a broad economic recovery, it may not lead to more stock gains in the near term, because the market has already soared in anticipation of a stronger economy.

The market is usually a few steps ahead like that, which makes predicting it nearly impossible. Thankfully, we don't need to know what it will do next. We have strategies that can profit whichever way stocks turn.

Profit whether up or down
Most of us have favorite stocks that we've been comfortable with for a long time, stocks we don't expect to soar anytime soon, but which we wish to own regardless. Maybe you'd like to buy more, too, if the price declined.

But it all depends on the market, right? If it goes down, you'll buy. If it goes up, you'll sit on what you have or sell at a higher price.

What you may not know is that those stocks could be generating profit for you even if the price they're selling for barely changes. In fact, this unclear market situation may be perfect for setting up income-generating option strategies called ... drumroll, please ... strangles and straddles.

Strangle profits from the market
Let's assume you own at least 100 shares of networking giant Cisco Systems (Nasdaq: CSCO), recently $24.30 per share. If the shares declined, you would be happy to add another 100 shares to your position. (All options contracts work in 100-share lots.) If the price appreciates, you'd be willing to sell your existing stock. This situation is ideal for writing (or selling) a strangle option strategy.

Writing a strangle, you sell put options on a stock at a strike price below the current share price, and sell covered call options on your shares, too, at a higher strike price -- selling the same number of contracts of each.

The puts obligate you to buy more shares if the stock falls by expiration, and the calls obligate you to sell your existing shares at a higher price if the stock appreciates by expiration.

You're paid for selling both options, putting significant income in your pocket:

Selling Puts
Cisco Systems
Selling Calls
Combined Options

July $23 strike pays you $1.18
$24.66
July $26 strike pays you $1.15
$2.33 payment to you, or 9% of the share price


Source: TD AMERITRADE quotes, Jan. 11.


This strangle trade pays $2.33 per share today, or $233 for every $2,466 in stock that you own. This 9% income is yours to keep.

Your obligations? If Cisco shares are below $23 by the July expiration date, your puts obligate you to buy more shares. Since you keep the $2.33 you were paid, your effective net buy price is $20.67 -- far below today's price. On the flipside, if Cisco is above $26 by expiration, you're obligated to sell your existing shares. Your net sell price equates to $28.33 -- a good sell price.

If Cisco is anywhere between $24 and $26 at expiration, both options you wrote expire, you keep the full payment, and you have no further obligations -- you just made great income even while the stock was flat. In fact, if Cisco is anywhere above $20.67 and below $28.33 by expiration, you can close your option trades for a partial profit and still not have any other obligations. That's a wide profit range.

Straddle your way to profits
Another way to squeeze profits from a stock is to write a straddle. The concept is the same as the strangle that we just explained, but here you use the same strike price on your calls and puts.

You generally use this strategy if you believe a stock is going to be less volatile over time, staying in a tight price range.

For example, Netflix (Nasdaq: NFLX) was up more than 80% last year. If you believe the stock is due to settle down, but you'd be happy to buy more shares cheaper or sell your shares higher, you could straddle the $53.30 shares with options today (this trade is ideal when the stock is right near an option's strike price, but here it's just $0.80 higher). Take a gander:

Selling Puts
Netflix
Selling Calls
Combined Options

March $52.50 puts pay you $3.60
$53.30
March $52.50 calls pay you $4.60.
$8.20 payment to you, or 15% of the stock price


Compared to a strangle, the straddle has much higher odds of resulting in a stock transaction, since you're using strike prices that nearly equal the current share price. If Netflix is below $52.50 by March expiration, you get to add to your position. Your effective net buy price would be $44.30. If Netflix is above $52.50, your existing shares would be sold, resulting in a net $60.70 sell price including everything the options paid you.

However, if Netflix is anywhere above $44.30 and below $60.70 by expiration, you can close your options for a partial profit, and keep your shares with no other obligations. That's another wide range for profits. Finally, if Netflix ends the expiration near $52.50, you'd make most of the $8.20 closing your options early.

Or, if you owned a position in Buffalo Wild Wings (Nasdaq: BWLD), the $40 stock offers a June $40 straddle that pays $8.80 right now. Would you be happy to buy more shares at a net $31.20 or sell your existing shares at $48.80? Or just make option profits as long as the stock is within this range? Bull or bear, it gives you plenty of room to earn option income. Other stocks with options that pay well include GlaxoSmithKline (NYSE: GSK), Hasbro (NYSE: HAS), Under Armour (NYSE: UA), and Apple (Nasdaq: AAPL).

Strangles and straddles summed up
To use a strangle or straddle strategy, you have to own at least 100 shares of a stock, you have to be willing to buy at least 100 shares more, and you have to be ready to sell your existing shares.

So, while the media and most investors obsess over the market's next move, you can set up strategies that will profit whether it's up or down. And if stocks stay in a range, as they eventually will following this record ascent, you'll be ready to keep right on profiting anyway.

http://www.fool.com/investing/general/2010/01/12/bull-or-bear-profit-anyway.aspx