Strategy for Flat Stock Markets


Everybody loves a bull market. Some people love bear markets. When there is a clear trend, you can trade up, or down, and lock in your profits as the trend ends. Most stock trading strategies work best in trending markets. But what do you do when the market sits, and trades flat for some time? Drifting markets are perfect for certain options strategies.

Short straddle

One of these strategies is called the buy write (bought shares plus a sold call option). This is a very popular strategy that allows you to earn extra income on your shares during a sideways trend. There is a limit to the upside, so it works only when the market is flat, or has a slow trend upwards. It does not work so well when the market has a strong trend upwards or downwards.

People familiar with options can see the flexibility and opportunities options and shares combined can be in a flat market. These are called multi-leg strategies. Selling straddles, or strangles are a great way of making money when the stock market is flattening out. Let me explain. Once you’ve determined the market as a whole is trending sideways, you can choose to sell a call option, and a put option. You can use this strategy on options for one specific company, or in the instance of a market lull, options based on the major index of your country.

For example, if after some investigations, you conclude a stock is going to hover around the $10 mark, you can sell a $15 call and a $15 put. You’ll earn two lots of premiums. In a flat market, you earn premium income even though the stock price has not moved. When the stock price moves away from $15, this will start eating into your profit. Your tolerance will be the amount of premium income earned.

This is referred to the straddle. The payoff diagram looks like someone straddling a horse or a fence, hence the name.

short straddle

Short strangle

In the instance you determine the stock market will trade within a particular range, you can use a strangle. It is simply a straddle with different strike prices for the respective legs. Say you estimate a stock to range between $20 and $21. A strangle with this view would be to sell the $20 put and the $21 call.

The attraction of this method is that because you are selling (writing) options you are being paid to implement your view. As with all options, the risk is that the market breaks out of the range, which will then result in a loss for the trade. The payoff diagram for a stangle is below.

short strangle

Breakout

If you anticipate a significant economic event is going to occur, but are not sure if the market will  go up or down, you can buy a straddle or strangle. This strategy costs money to implement because you are buying two legs – a  call option and a put option. You need the market to move strongly in one direction, enough to cover the premium for both legs of the trade, and a the brokerage fees.

If the market does not move as you predict, your maximum loss is the premium you paid for the options. The upside of this strategy is unlimited, and only restricted by how far the market can move in either direction during the life of the options.

Options are more geared towards the experienced investors. Please ensure you familiarise yourself with the market, and options before diving into any risky ventures.

Good luck with your future trades.