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.
Vertical spread options
Vertical spreads are a combination of long and short calls or long and short puts in the same expiration. To set up a long call spread, you would buy a lower strike call and sell a higher strike call against it. The main advantage of this strategy is that the sale of the upside call can significantly reduce the initial premium outlay when putting on the trade. However, the sale of this upside call also caps the profit potential of the trade. You shouldn’t participate in any move above the short call strike.
When using the measured move target, always be sure to sell the strike closest to the target. This is the level the market is implying the underlying can reach, thus where you would want to set up for point of maximum profit.
Example: We buy the E-mini Aug. 9 weekly vertical spread of 1715-1720 for 0.90. The trader is buying the 1715 calls and selling the 1720 calls for a 0.90 net debit. The risk is $45 per one-lot. The potential reward is $205 per one-lot. Breakeven is 1715.90.
To take a bearish view on the market, a trader could use a vertical put spread. This involves buying a low strike put while selling a lower strike put. As with the long call vertical, a long put vertical is established for a lower initial premium outlay but has a capped profit potential. Again, look to sell the strike closest to the downside measured move target.
Example: We buy the E-mini Aug 9 weekly vertical spread of 1685-1680 for 0.85. This involves buying the 1685 puts while selling the 1680 puts for a 0.85 net debit. The risk is $42.50 per one-lot. The potential reward is $207.50 per one-lot. The breakeven is 1684.15.
Both of these strategies set up for well-defined reward-to-risk ratios and carry less risk than outright calls or puts. The muted effect that implied volatility changes have on these positions is also a factor that makes them particularly attractive around catalyst events.
Butterflies aren’t free
Because you’re able to calculate an accurate target ahead of a catalyst event, you can set up advanced strategies that allow for a huge profit potential on invested capital. Butterflies are an example of a spread that uses a specific target yet still profits within a range. Using the measured move target can greatly increase your chance of success when trading butterflies.
A butterfly basically is a combination of a long and short vertical spread. For example, a call butterfly would involve buying the E-mini 1715-1720-1725 call butterfly for 0.25. Here, we are buying the 1715 call, selling two of the 1720 calls and buying the 1725 call. This sets up the same as buying the 1715-1720 call spread while selling the 1720-1725 call spread. The risk for this trade is $12.50 per one-lot, with a potential reward of $237.50. Breakeven is at 1717.25 and 1724.75.
While butterflies usually set up for large reward-to-risk ratios, the profit potential of this trade is not typical. Returns in the area of eight- or nine-to-one are more typical. Again, sell the strike closest to the upside measured move target. In this case, it is the 1720 strike. “Call butterfly profits” (below) illustrates the profit zone for this trade.
In a put buying example, we would buy the E-mini Aug. 9 weekly 1685-1680-1675 put butterfly for 0.30. Here you would buy 1685 puts, sell two 1680 puts and buy 1675 puts. This sets up the same as buying the 1685-1680 put spread while selling the 1680-1675 put spread. The risk is $15 per one-lot. and the reward is $235 per one-lot. The breakeven is 1684.7 and 1675.3. “Put butterfly profits” (below) shows where the market must move for this trade to be profitable.
Using the downside measured move target, you’re able to set up a bearish trade with a great reward potential.
Using measured move targets to trade catalyst events can be profitable, but there are other applications for them as well. For example, if you trade income strategies you can use the measured move targets to decide which strikes to sell. Selling strikes outside of the upside and downside targets can increase the probability of success greatly.
With securities that have weekly options, you can calculate the measured move targets in every expiration and set up strategies accordingly. Volatility traders also can use the straddles in different expirations to draw conclusions about what market expectations are in each of those expirations. For example, in weekly options the week that contains a major market-moving event always will have a higher implied move than one that does not. Some traders might find the differences in these implied moves to be too wide or too tight and can set up a trade accordingly.
Traders who only trade in the underlying also can use the measured move targets for setting stop losses and profit targets. The number of applications for measured move targets are significant. Knowing what these levels are can be useful information for all traders.
There are dozens of indicators that can be used to project price targets for a given security. None of these indicators works as well as using the options market to calculate measured move targets. Technical indicators use historical price action and many are open to interpretation. Using the at-the-money straddle to calculate price targets is much more accurate because it is the truest representation of real-time market expectations.
Andrew Keene was an independent equity options trader on the Chicago Board Options Exchange for 11 years. During that time, he was a market maker in more than 125 stocks including Apple, General Electric, Goldman Sachs and Yahoo. His is author of “Keene On The Market: Trade to Win Using Unusual Options Activity, Volatility and Earnings” (John Wiley & Sons). Email him at Andrew@KeeneOnTheMarket.com.