From the October 2013 issue of Futures Magazine • Subscribe!

Using options to trade with measured-move targets

The trading week is full of catalyst events. Economic data, earnings announcements, crop reports and inventory numbers are just a few examples of market-moving catalysts. Usually traders associate these events with increased risk because of the wild movements markets can experience afterward. It is true that these periods can be difficult to trade, and they often can require a trader to assume uncomfortable levels of risk. Picking price targets around these events can present a similar challenge.

Despite these challenges, trading catalyst events can offer excellent opportunities to profit using a systematic and methodical approach. The options market and measured-move targets are two ways for a trader to approach catalyst trading. The trading plan described here covers a systematic approach to determining price targets, setting up strategies and managing risk around market-moving events. This trading plan is applicable to any security that has listed options including equities, exchange-traded funds and futures. 

When trading any catalyst event, the first thing to do is calculate the upside and downside of the measured-move targets. These targets are levels that the options market is implying the underlying will be at on expiration of that options series. (Because options are used, this method does not work for a security that does not have options available.)

To calculate the measured-move targets, first look at the price of the at-the-money straddle, which is an options spread that is constructed by buying both the at-the-money calls and the at-the-money puts. Consider this example:

  • E-mini S&P 500 futures are at 1700
  • Aug. 9 weekly 1700 calls are at 9.25
  • Aug. 9 weekly 1700 puts are at 9.50

This means that the Aug. 9 weekly straddle is trading at 18.75. The price of the at-the-money straddle tells us where the options market is implying the underlying can be by expiration. The straddle price shows expected movement higher or lower.

A key point here is the straddle shows the implied move by expiration of this specific options series. This means that when trying to determine the expected move on a catalyst event, you would always use the closest to expiration options that still contain the event. For example, if you are trying to calculate the expected move in the E-mini S&P 500 futures going into the release of the unemployment number, you would use the weekly options that expire that same day. Nearer-term options always will give the most accurate targets. 

Once you’ve determined the price of the at-the-money straddle in the expiration that contains the catalyst event,  use it to calculate upside and downside targets.

To calculate the upside target, add the strike price and the straddle price. For our example, this is 1718.75 (1700 + 18.75). To calculate the downside target, we subtract the straddle price from the strike price. For our example, this is 1681.25 (1700 – 18.75).

This means the options market is implying that E-mini S&P 500 futures will close at either 1718.75 or 1681.25 on Aug. 9 expiration. Now you can use targets to set up an options strategy. These targets will be more accurate than targets calculated using wave patterns, Fibonacci levels or other technical analysis methods because they are calculated using actual market prices inherently representing market expectations.

Unlike trading the underlying into a catalyst event, the leverage of options allows you to establish a trade with an excellent risk vs. reward setup. Several strategies will work best when set up around the measured move targets.

In general, trading outright calls and puts during catalyst events is not the most effective strategy. Because of the uncertainty surrounding the event, implied volatility will be inflated and options premiums can be relatively expensive. Immediately after the event, implied volatility will fall drastically, decreasing the value of any long premium. The best way to counter the implied volatility effect is to use options spreads. 

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