Sideways Market: 3 Effective Options Strategies
Sideways Market: Due to the stock’s tendency to trade in a narrow range between support and resistance, traders frequently find it challenging to profit from stocks in “sideways markets.” When the stock is anticipated to continue trading in sideways market conditions, options strategies provide traders with a distinctive means of profiting.
What Does Sideways Trading Mean?
Many traders have the knowledge and skill sets necessary to recognize market signs that could point to an uptrend or fall in a company. However, what should a trader do when market conditions are calm, and the movement of stocks is within a tight range? This lack of material movement in stock either up or down is what many traders call a “sideways market”. In this market, where price action volatility is low, some traders have a hard time turning a profit.
How to Identify a Sideways Market
A sideways market can be identified by a variety of approaches. Simply looking at a daily chart of a stock’s price movement over any given period of time is one technique frequently used by traders to spot a sideways market. A stock is said to be “trading sideways” if its price appears to be fluctuating within a constrained vertical range, also known as support and resistance levels. However, there are two practical technical indicators that might provide traders a reliable tip.
1. The Average Directional Index
One sign of a sideways market is the ADX, or Average Directional Index. It is a technical indicator whose output ranges from 0 to 100, with a value below 25 indicating horizontal price action, which is a sign of a sideways market. It is calculated by comparing the ior prices of a stock to its current price. The chart below illustrates how a trader might have used an ADX signal below 25 to properly predict a sideways market in the Euro
When employing technical indicators like the ADX or RSI signal to identify sideways markets, traders typically have problems knowing how to take advantage of these conditions. After all, how could trading in stock with negligible up- or down-movement possibly be profitable? The employment of multiple options techniques, which are detailed in more detail below, is the solution.
2. The Relative Strength Index
Another technical indicator that traders can use to spot narrow price action in a stock is the relative strength index or RSI for short. Similar to the ADX indicator, the relative strength index determines if a company has trading momentum in a specific direction by factoring in prior price movement. An output between 40 and 60 typically serves as a reliable indicator of a sideways market in that particular stock. This indicator generates a reading between 0 and 100. The chart below illustrates how a trader may have used the RSI signal between 40 and 60 to correctly predict a sideways market in the Euro.
Options Trading Strategies to Use in Sideways Markets
Market sideways trading frequently results in minimal volatility. An important factor in determining an option’s price is volatility or the range of a stock’s price movement over a specific time period. All other things being equal, the price of the option on a stock will be higher the more volatile the underlying stock is. Therefore, options can be used as the preferred financial tool to trade lower volatility, which is frequently the result of a sideways market. (Note: If you need to catch up on the foundations of options trading, you may start with a rudimentary )
Strategy 1: Short Straddle
The so-called straddle is one of the most popular options strategies among traders trying to wager on volatility. The purchase of one call and one put on the same stock at the same strike price, often the strike price closest to the current price of the underlying company, is known as a straddle. Each of these options’ expiration dates is referred to as a “option leg” of the straddle.
The value of the straddle at expiration is unaffected by changes in the price of the underlying stock because the call earns money when the price of the underlying stock rises above the strike price and the put makes money when the price of the underlying stock falls below the strike price. A payoff graph that demonstrates this is provided below.
The profit and loss of the straddle are indicated on the y-axis of the above chart as changes in the price of the underlying stock are shown on the x-axis. The straddle shown above has two option legs: 1.) a call option with a $40 strike price and premium expense of $2.5; and 2.) a put option with a $40 strike price and premium expense of $2.5. The underlying stock for both straddle’s legs is the same and both legs expire on the same day. The underlying stock must go above $45 or below $35 to pay out, which is equal to the straddle’s strike price plus or less the trader’s entire premium investment of $5.
So how does one profit in a sideways market utilizing the same tool? by either shorting or selling the straddle. The sole distinction between the short straddle and the long straddle outlined above is that the trader sells both straddle legs rather than purchasing both straddle legs. Let’s look at what a payment chart may look like for a short straddle:
In this instance, the trader receives a $2.5 premium for selling a call option with a $40 strike price. Selling a $40 put on the same stock with the same expiration for $2.5 in premium constituted the second leg of the trade. In this case, 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 trader can still make money in a sideways market because the profit will never be greater than the whole premium they received.
Strategy 2: Short strangle
The only difference between the strangle and the straddle, an earlier described options strategy, is the strike prices used to build the strategy. Unlike a straddle, a strangle’s two legs are created by a call and a put option, and unlike a straddle, the strangle legs are bought at various strike prices that are typically equal distances from the stock’s current price. A trader can benefit from limited price action in a stock trading in a sideways market by using the short strangle method. The following payoff chart shows the short strangle’s profit and loss as the price of the underlying stock fluctuates:
The short strangle in the illustration has two legs: a call with a strike price of $45 and a put with a strike price of $35. The short strangle’s two legs are both for the same underlying stock and have the same expiration date. The technique incurs a loss as the stock deviates from the purchase price at the time of the short strangle buy. However, in a sideways market, the short strangle in the aforementioned example would be advantageous if the stock varied between $32.5 and $47.5.
Strategy 3: Iron Butterfly
A third option method widely utilized by traders to rake in gains in sideways markets is termed an iron butterfly. An iron butterfly could be thought of as a combination of the aforementioned tactics with a small difference.
The trader enters a position using an iron butterfly by selling a call at the strike price that is closest to the current price of the underlying stock, selling a put at the strike price that is next to the current price of the underlying stock, buying a call at a strike price that is higher than the current price of the underlying stock, and buying a put at a strike price that is lower than the current price of the underlying stock.
One will note that legs 1 and 2 are simply a brief straddle while legs 3 and 4 are a long strangle. This four-leg options strategy, which is shown in the payoff chart below, enables the trader to profit from a sideways market while limiting losses:
What Takes Place Following a Sideways Market?
After a sideways market, a stock will sometimes suffer a period of volatility. This volatility most likely arises from the stock’s transition from a period of close trading between price levels of support or resistance to a bull or bear market. The chart below provides an illustration of this, showing a stock that transitioned from multiple trading sessions of a bullish rise to a sideways market, trading in a constrained range of price action:
Final Reflections
A sideways market is a market in which a stock trades within a tight price range. It is challenging for traders to generate money using long or short positions in the stock itself because of this small range. Instead, traders can utilize options methods, such as a short straddle, short strangle, or iron butterfly, to earn money as the stock continues to trade in this sluggish market with low volatility.
FAQ
What is the ideal option strategy for a sideways market?
Sideways market option strategies
One such sideways option strategy is a short strangle. This entails simultaneously selling a put and a call on the same securities. In the event that both options expire worthlessly, which is more likely to happen in a sideways market, the seller keeps the premium he received for both.
What are directional options strategies?
Investors can profit by placing bets in the market’s direction by using the directional options technique. Bull calls, bull puts, bear calls, and bear puts are the four different sorts of strategies. The tactics result in reduced payoffs while assisting in lowering option costs, volatility, and risk.
What is the best approach to trading options?
The most profitable options strategy is to sell out-of-the-money put and call options. This trading method enables you to gain significant amounts of option premiums while also lowering your risk. The annual profits for traders who use this approach can reach 40%.
Which option strategy is best?
Straddle is considered one of the top Option Trading Strategies for the Indian Market. One of the simplest market-neutral trading strategies to use is a long straddle. Profit and loss are unaffected by the direction of the market’s movement once it has been applied.
