Traders often find it difficult to profit from stock in “sideways markets” as the stock trades within a narrow range of support and resistance. Options strategies offer traders a unique method of making money when the stock is expected to continue to trade in sideways market conditions.
Many traders are well equipped with the knowledge and skill sets to identify signals in the market that may indicate a stock’s uptrend or downtrend. However, what should a trader do when market conditions are calm, and movement of stocks is within a tight range? This lack of material movement in a stock—either up or down—is what many traders call a “sideways market”. This is a market in which volatility of price action is low and some traders have difficulty making money.
A sideways market can be identified through a variety of methods. One method often used by traders to identify a sideways market is by simply looking at a daily chart of a stock’s price action over any given period of time. If the price of the stock seems to be trading within a narrow vertical range, sometimes referred to as support and resistance points, that stock is said to be trading “sideways”. However, there are two useful technical indicators that can offer a quality signal to traders.
One indicator of a sideways market is the ADX, or Average Directional Index. It is a technical indicator that is calculated by using prior prices of a stock relative to its current price to produce a number between 0 and 100 where an output under 25 indicates horizontal price action that is indicative of a sideways market. The chart below illustrates how a trader could have used an ADX signal below 25 to correctly predict a sideways market in the Euro.
When using technical indicators like the ADX or RSI signal to identify sideways markets, traders often have trouble understanding how to take advantage of these situations. After all, how could you possibly benefit from trading in a stock with little movement up or down? The answer is through the use of various options strategies that will be described in detail below.
The relative strength index, or RSI for short, is another technical indicator that traders can use to identify narrow price action in a stock. Similar to the ADX indicator, the relative strength index is calculated using the inputs of prior price action to indicate if a stock has trading momentum in a particular direction. This indicator outputs a reading between 0 and 100 in which an output between 40 and 60 typically is a good indication of a sideways market in that particular stock. The chart below illustrates how a trader could have used the RSI signal between 40 and 60 to correctly predict a sideways market in the Euro.
When markets are trading sideways, volatility is often low. Volatility, or the dispersion of a stock’s price action over a given period of time, is a material component to the pricing of an option. The higher the volatility of an underlying stock, all else equal, the higher the price of the option on that stock will be. Therefore, reduced volatility that is often the result of a sideways market can be traded using options as the financial instrument of choice. (Note: If you need to catch up on the basics of options trading, you might start with a rudimentary like Put vs. Short.)
One of the most widely used options strategies among traders looking to bet on volatility is what is called a straddle. A straddle is a type of trade that involves purchasing 1 call and 1 put on the same stock at the same strike price, typically the strike price closest to the current price of the underlying stock, and expiration date—each of these options are called an “option leg” of the straddle. Since the call makes money when the underlying stock price rises above the strike price and the put makes money when the underlying stock prices declines below the strike price, the straddle’s value at expiration does not change with changes in the underlying stock price. Below is a payoff chart that illustrates this concept:
The chart above depicts the straddle’s profit and loss, shown on the y-axis, as the underlying stock price, shown on the x-axis, changes. The straddle depicted above consists of 2 options legs: 1.) a call option with a strike price of $40 that cost the trader $2.5 in premium and, 2.) a put option with a strike price of $40 that cost the trader $2.5 in premium. Both legs of the straddle expire on the same day and are for the same underlying stock. Since the trader paid a total of $5 in premium, the underlying stock must move above $45 or below $35 to pay off—this is simply the strike price of the straddle plus or minus the total premium paid. In other words, the long straddle only pays off if there is volatility in the stock—the opposite of a sideways market.
So, how does one make money using this same instrument in a sideways market? By selling or, shorting, the straddle. The short straddle is very similar to the long straddle discussed above with the only difference being that the trader is selling both legs of the straddle as opposed to buying both legs of the straddle. Let’s look at what a payoff chart might look like for a short straddle:
In this case, the trader sells a call option with a strike price of $40 and gets paid $2.5 in premium. The second leg of the trade involved selling a $40 put on the same stock at the same expiration for $2.5 in premium. In this situation the trader has received a total of $5 in premium and will make money if the underlying stock price stays within a range of $35 to $45. The profit will never exceed the total premium the trader received; however, it allows the trader to make money in a sideways market.
The strangle is an options strategy that is very similar to the previously discussed straddle—with the one difference being in the strike prices used to construct the strategy. With a strangle, a call and a put option create the two legs of the strategy and, unlike a straddle, the strangle legs are purchased on different strike prices that are typically equidistant from the underlying stock’s current price. A short strangle strategy allows a trader to take advantage of narrow price action in a stock trading in a sideways market. The payoff chart below illustrates the profit and loss of the short strangle as the price of the underlying stock changes:
The depicted short strangle consists of 2 legs: 1.) The trader shorts a call with a strike price of $45 and, 2.) shorts a put with a strike price of $35. Both legs of the short strangle have the same expiration date and are for the same underlying stock. As the stock moves further away from the current price at the time of the short strangle purchase, the strategy leads to a loss. However, in a sideways market the short strangle would be profitable in the example above if the stock traded within a range of $32.5 and $47.5.
A third options strategy often used by traders to rake in profits in sideways markets is called an iron butterfly. One could think of an iron butterfly as a combination of the previously mentioned strategies with slight variation. With an iron butterfly, the trader enters a position in 4 options legs: 1.) Sell a call at the strike nearest the current price of the underlying stock, 2.) sells a put at the strike nearest the current price of the underlying stock, 3.) buys a call at a strike price that is greater than the current price of the underlying stock and, 4.) buys a put at a strike price that is less than the current price of the underlying stock. One will notice that legs 1 and 2 are simply a short straddle and legs 3 and 4 are a long strangle. As depicted in the payoff chart below, this 4-leg options strategy provides the trader with the opportunity to profit off a sideways market while limiting losses:
In this situation, the trader’s downside is limited due to the purchase of legs 3 and 4 that provide loss support if the underlying stock’s price moves outside of the long call or long put purchased by the trader.
After a sideways market, a stock will sometimes experience a period of volatility. This volatility is likely the result of the stock moving from a period of narrow trading between a price level of support or resistance to a bull or bear market. An example of this can be seen in the figure below, which shows a stock that has been in a sideways market—trading in a narrow range of price action—to several trading sessions of a positive uptrend:
A sideways market is a market in which a stock trades within a narrow price range. This narrow range makes it difficult for traders to profit using long or short positions in the stock itself. Instead, traders can utilize options strategies, such as a short straddle, short strangle or iron butterfly, to make money as the stock continues to trade in this sideways market with little volatility.
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