Making money off volatility

Markets go up, markets go down. What if there was a way to make some scratch simply off the movement, regardless of the direction?

I did a trade last week, that worked out fairly well, netting me about a 20% return in less than one week. The only danger in this strategy is that we have an extended "flatline" in the market. Given the issues the stock market has to face these days (will the FASB rescind mark-to-market? Will they nationalize banks? Are pension funds going to go belly up from private equity deals gone bad? Will the SEC restore the uptick rule? Is inflation coming? Will muni bonds get destroyed if cities follow Vallejo into bankruptancy? Are unemployment numbers going up?) I feel it is safe to say that one way or another, market will move up a fair amount OR down a fair amount. You need about a 3 or 4% index move within a month for this strategy to work -- I feel comfortable saying that will occur!

I will present my trade and then present another for consideration. In one month or less, I will revisit this trade and show its value -- positive or negative.

Lets review some facts about options.

Calls are an option type that when bought, allow you the opportunity to buy a certain number of shares at a certain price, by a certain date. (when sold, it obligates you to sell that certain number of shares at a certain price, by a certain date)

Puts are the reverse -- when bought, they allow you the opportunity to sell a certain number of shares at a certain price, by a certain date. And conversely, selling the same obligates you to buy those shares, etc. etc.

Very simple example -- my favorite stock of the moment is Dendreon, and it trades at about $4.20 a share right now. By the end of April, they will announce final IMPACT trial results for their prostate cancer vaccine Provenge, and the stock will VERY LIKELY be either much highr or much lower. If I buy a call option contract for the May 2009 $10 strike (ticker UKOEB), I would pay $112 (plus commission). That contract allows me to buy 100 shares of DNDN for $10 per share anytime on or before May 15. Why on earth would I PAY money to buy a stock at a higher price than I could pay right now? Because I don't actually have to spend the $420 right now to buy those 100 shares -- and I expect IMPACT to be successful and the share price to be much higher than $10 before May 15!
Let's take the worst case scenario first: IMPACT fails, and the stock craters (or more precisely, it does not go above $10). In that case, I have spent my $112 for naught.
In the great case, let's say IMPACT is a stunning success and the stock goes to $25. (it did precisely that 2 years ago, before the FDA said, finish this trial to see if you can replicate the results) Buying 100 shares would then cost $2500, but my option contract allows me to buy those 100 shares at $10 each, or for $1000. Really, it would be for $1112; the stock price plus what I paid for the option, plus commissions... but then I could turn around and sell those 100 shares for the $2500. So -- I would have made $2500 - 1112 = $1,388, all for my original $112.

One extra nice thing about options is that you don't actually have to exercise the option (trade it in for the stock) -- the option price for a $10 call for a stock trading at $25 would be slightly higher than $15. So I could simply sell the call (that I bought for $112) for around $1500. Of course, if the stock is only at $12, the option is only worth $200 and so the profit goes way down. It is simply leverage -- controlling 100 shares at a time.

So: buying calls indicates you want the stock to go up. Buying puts is the reverse -- you want the stock to go down. A relatively small move in the underlying stock can move the option a bit less, but with your leverage it works to your favor.

My trade from last week was against the Nasdaq 100 tracking stock, ticker QQQQ. It was at $29.56 and I did NOT know whether the Nasdaq was going up, or if it was going down. BUT -- with all the "stuff" happening in the world, I was pretty confident that it would go up OR down more than 3% within a month.
So I bought two April $29 calls AND two April $30 puts. The two calls cost about $290 and did the two puts cost about $320. Within 4 days, the Nasdaq had gone up to about $30.60 (less than a 4% move) and the two calls were worth $580. The puts, however, had gone down in value to about $165. I then sold BOTH my calls AND my puts... netting me, after all commissions, about $120. Having spent just over $600 on the entry, there is my 20% return.

The reason this is successful is because the successful side just about doubles, while the losing side only halves. Another trick would be if you can make 125% on the successful side (and sell it) and keep the other side open. If the market goes back the other way, you can then sell that back fora smaller loss (or wow -- maybe even a gain also!) -- but the trick here is that once you have a TOTAL gain of 20%+, you close it out and lock it in.

So here is the trade to follow for the next few weeks:

The QQQQ closed tonight (4/1/09) at $30.77. For this trade I'll still buy the April contracts, although I suppose we can also track the May amounts to see where that leads us. Ideally I'd like it to be at either an even dollar amount (say, $31 -- and then I'd buy the $30 calls and the $32 puts) or halfway in between ($30.50 - and I'd buy the $30 calls and the $31 puts) but I'll make it even on the sides by buying two calls and three puts. I've listed the data below:

Strike Date Strike Price Type Contract Price
April $30 Call $150
April $31 Put $114
May $30 Call $216
May $31 Put $181

So the April strike would cost 2*150+10 + 3*114+10 (I'm including a $10 commission here to make it more realistic). So total "in" costs $662. I'd be looking for 20% profit, or about $135.
The May strike would cost 2*216+10 + 3*181+10, or $995. Profit expected would be $200. In both cases, a 4% move should do the trick, if within a week. Please note that the May strike gives much more upside if you were looking for more than 20% profit, since we have 45 days instead of only 16 more days as in the April case. I expect several rather severe moves up AND down in the next couple months!

Regards,
Trond