Updated: Dec 25, 2022
Almost everyone knows you can make money as a stock goes up, a lot of people understand you can make money as a stock goes down, but not as many people realize you can make money as a stock trades sideways in a range.
There are several trade strategies that actually pay you as a stock moves sideways. These trades benefit from the passage of time and decreases in Implied Volatility (IV). All of the trades we are discussing today are referred to as directionally neutral. As always we have to consider our risk. There are two types of directionally neutral trades: Defined Risk and Undefined Risk trades.
Defined Risk trades have a defined maximum loss. Since the risk is limited your normally also limit or reduce the profit as well. This is not a negative as you can still find trades with a good risk to reward. For beginners with smaller accounts a risk defined trade is a great starting point as defined risk trades use less buying power in addition to having a maximum loss if you are wrong.
Undefined risk trades means you can lose an unlimited amount in theory, in reality the worst case is you lose a large amount of money; however, you also have the potential unlimited profits (in theory). More risk often carries the potential for more rewards, but be careful because one bad trade can erase the wins of 100 winning trades. If you are trading undefined risk trades you must have a plan if (when) the trade goes against you. Knowing your plan and exit options before entering the trade enables you to make educated decision that aren't fueled out of fear or emotion.
Let's briefly discuss a couple defined and a couple undefined risk trade strategies you can use to make money as a stock trades sideways or within a set range.
Reminder of common acronyms: In-The-Money (ITM) At-The-Money (ATM) Out-of- The-Money (OTM), DTE (days to expiration)
An Iron Condor (IC) is setup as a single order in the broker, but composed of 2 vertical spreads (a call and a put spread). IC's are a great way to get exposure to a stock without taking a directional value. A short put spread is bullish, the short call spread is bearish. Both trades offset each other and it's impossible for both side of the spread to lose as the underlying can't trade in two ranges at expiration.
A Butterfly is typically created using a ratio of calls or puts where you have a ratio like this: 1 - 2 - 1. The trade is referred to as a butterfly because the ratio looks like wings on the outside with the body having an extra contract. I'll discuss it in terms of calls, but you can also do this with puts, you do not mix calls and puts in this trade. 1 IITM call, 2 ATM calls, and 1 OTM call. Although these trades often have lower probabilities of profit (POP) these trades are great when there is high volatility and you expect the underlying to remain in a tight range.
A strangle is composed of 1 OTM call and 1 OTM put with different strike prices, but the same DTE. Although you can buy or sell strangles, selling strangles is the directionally neutral strategy. When selling a strangle you are selling a call and selling a put. Often you sell the option around the same delta (between 10-30 delta). Strangles are very similar to an Iron Condor, you just don't have the protection of the long call and put. If the stock breaks outside of the range you can incur a large loss. There is a lot of flexibility in managing these trades which is good if you understand, but it's bad if manage at the wrong time or make the wrong adjustment. The best case scenario is the stock stays between both strikes and you collect all the premium you collected.
A straddle is composed of 1 ATM call and 1 ATM put so the strike price is the same and the DTE is the same. Straddles will pay more premium than a strangle, but you are also taking far more risk. The increased premium makes for a wider break evens, but short calls are a major risk if the stock has a large move to the upside. If you trade straddles there needs to be very high volatility and you need a high confidence level in your trade with very a defined exit strategy if the trade goes against you. GKT disclaimer: Although this trade is commonly discussed, I do not typically sell straddles as the increased premium is not worth the added risk for me.
My preferred strategies for directionally neutral trades are Iron Condors and Strangles. Both of these strategies are key components to my success! There are lots fine details to consider and discuss, but today the main purpose is to bring awareness. No matter which strategy you decide to use it's important to recognize that you can make money as stocks trade sideways. There are strategies that work in every market direction.
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