Summer Range Trade and Volatility Crunch

As the S&P 500 Index sits comfortably above 900 in mid-June, investors and traders prepare for a much-needed rest from the volatility and uncertainty of the past year. The market may therefore shift into a cycle of range trading and lower volatility as it takes a breather. With banks and auto companies on the mend, Fed policy stable and supportive, housing and consumers contracting less aggressively, and bottoming fundamental data flowing in from many fronts, the only volatility event on the near-term horizon is second-quarter earnings season, which begins in July.

One way that professional options traders take advantage of this opportunity—call it a “wall of worry” or just plain exhaustion—is to become net sellers of volatility. The option pros like to sell “relatively” high implied volatility because they believe the odds are in their favor for volatility to revert to the mean, relative to historical volatility. One way to approach this conservatively is to look for strong stocks or sectors that are establishing a trading range for the time period you are interested in.

A strong sector I believe is poised for a trading range is energy, especially with crude oil still in a strong rally mode. I expect another strong move up through $75 this summer, even if the fundamental economic conditions don’t justify it. Crude could trade as high as $85, before it settles down and heads back toward the bottom of its new higher range near $60.

I did a scan yesterday on the Idea Generation Platform for such a situation and found a promising candidate: the Energy Select Sector SPDR (XLE) with an iron condor trade idea. The XLE is a large basket of stocks in the oil and gas exploration and service areas. If you look at the chart of the XLE, you see the strong rally of this basket of energy names along with crude. I expect the solid bottom at $40 to hold with strong buying support above $45 with oil above $55. I also expect the XLE not to rally as aggressively as oil, finding significant resistance near $60. The XLE is currently right in the middle of this range at $50 and I think it will stay there for the summer.

Here’s how the trade works to take advantage of these conditions: an iron condor involves selling two out-of-the money vertical spreads simultaneously. In other words, we sell a call spread near the top of the expected range, and we sell a put spread near the bottom of the expected range. The ONN Idea Generating Platform found a September iron condor selling the 58/60 call spread for about 30 cents and selling the 40/42 put spread for about 33 cents. This would result in a net credit on the iron condor of 63 cents. The maximum risk would be $1.37, which is the $2 difference between the strikes of either one of the spreads (since we can’t lose on both) minus the premium received of 63 cents. And the return on investment (ROI) is about 45% in three months, not counting transaction charges.

Ideally, we want the XLE to stay between $42 and $58 until September options expiration so that we keep the entire credit of $63 per 100 shares. From $50, that would equate to a 16% move in either direction. A 16% move in the next three months would equate to about 32% annualized volatility. These credit spreads are trading for about 35% to 40% annualized volatility, so I am very comfortable selling volatility premium in this environment, in this strong sector, and the iron condor is a perfect way to do it.

Mind the risk, bank the profits!