The following is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences with anyone who is interested.

Options can be a useful tool not only to limit losses due to whipsaw, but to actually use whipsaw as a means of generating income. Let’s face it; stock prices rarely move in a straight line, often retracing their previous movements many times, even during strong trends. Setting stops on a stock trade can be especially frustrating when whipsaw causes on otherwise profitable position to get tripped out too early.

Fortunately there is a relatively simple option trade that is very efficient at capturing gains when the market is choppy, without giving up potential profits if a strong trend develops. It begins with an at-the-money straddle; a long call and long put at a strike price very close to the underlying stock price. On some volatile stocks or ETFs, the underlying price may swing up and down several dollars in a single day, with each retracement crossing the strike of the straddle. For example, on the triple leveraged ETF FAS, whipsaw has resulted in the $80 intraday level being crossed a dozen times or more in the past ten days. Although the trading range was generally between $76 and $84 during that period, the shares are now trading very close to their original level; the worst possible scenario for a long straddle.

In order to turn a long straddle into a whipsaw generator, options need to be sold to recoup the initial outlay of premiums. When the share price increases $1 over the $80 strike, the $81 call can be sold for approximately the same premium that was paid for the $80 call. The risk lies in the possibility that the trend continues without whipsaw, causing the long put to expire worthless. Even so, the call spread that was created would then expire with a $1 profit that would offset some of the loss on the put. With a $1 stop loss on the put, even that risk can be minimized. However, if the price retraces back down to the $80 level, the put can usually be sold with only a small loss of time value.

Even better, if the price declines to $1 below the $80 strike, rather than sell the $80 put, the $79 put can be sold. The end result is a combined put spread and call spread resembling a reverse iron butterfly. The only difference is that the premiums paid for the $80 call and put are nearly identical to the premiums received on the $81 call and $79 put. The butterfly therefore has virtually no body; only wings. No matter where the underlying price ends up at expiration, the trade will turn a profit or break even. In most cases, one spread or the other will expire with a gain of $1 per share. Depending on volatility, it is sometimes possible to open all four positions on the same day. What’s more, if some major event shakes up the market before the short options can be opened, the long straddle may become profitable on its own.

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