Playing The Range In This Wacky Market

Given the tight range many
stocks are trading in, I thought it prudent to take a look at doing some
limited-risk credit spreads. I will be on Bloomberg Television tomorrow
morning at 7:30 ET with Dylan Ratigan explaining the following credit spread
and one for index options as well.

Micron
(
MU |
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PowerRating) @ $39

Given the the stock has
been stuck in that $35 – $45 range, you may think that this is a perfect
candidate for some premium selling. If a premium seller sold the September 37 ½ put for
$2.60 and the September 42 ½ call for $1.70, he’d collect a total of $4.30.
However, if Micron makes a breakout move to the upside or downside, he’d
quickly discover why they call this spread a strangle!

A safer way to play the same
game is through a pair of credit spreads that traders refer to as a
“4-Way." In a 4-way, he’d still sell that September 37 ½ put and the
September 42 ½ call, but the premium seller would hedge his risk by buying the September 35
put and the September 45 call. With these two purchases against his shorts,
he’s greatly reduced his risk and margin, as he will not be net
short any contracts.

The cost of buying the
September 35 put would be $1.70, and it would cost him $1 to protect his short
September 42 ½ call by the purchase of a September 45 call. Thus, the net
credit for the call and put sale were $4.30 and the debit for the protection
was $2.70, for a net credit of $1.60.

If Micron stays between the
strikes he’s picked (short 37 ½ put and 42 ½ call), he keeps the entire
$1.60 per contract. Since he’s effectively sold a $2.50 call spread and a
$2.50 put spread, the most either side can expand to is $2.50. Therefore, if
Micron breaks out of its range, he is only risking the difference between his $1.60 credit and $2.50, or a total risk of $.90 per contract.