Establishing a DIA Strangle

Add DIA April Calls

By Bryan Bottarelli
Tuesday, March 18, 2008 10:26 AM EDT
Tue, 18 Mar 2008 14:26:00 GMT

*DIA STRANGLE PLAY: Buy the DIA April 125 Calls (DAW DU) at or under $2.25, good for the day.

Dear Bottarelli Research Member,

The Dow opened the day +200 points.

This gain is coming in advance of the next Fed decision, which is expected at 2:15 Eastern Time. From the looks of things, the market is already pricing in the extremely rare one percentage point cut in the Fed fund rate. If this happens, it’ll lower rates to 2%.

But for traders like us, the more important question is this: How will the markets react to this afternoon’s Fed news? After all, it’s very rare that we see a 1-point cut, especially under these current circumstances, so it’s not easy to determine the market’s reaction. That’s why we’ve seen such wild intra-day price swings (most of which have been exacerbated by artificial market stimulants, I might add).

From my perspective, here is what we’re looking at. If the Fed cuts rates by 1 point, the markets might be pleased — and initially rally in the moments after this cut is announced. But then, as reality sets in, I fear that the bears will short this upside strength. If the Fed cuts only 75-basis points (or less), I think the markets will sell off quite aggressively. And of course, there could also be some sort of “wild card” where the Fed (in conjunction with the bank of Japan, for example) pulls another rabbit out of their hat.

Either way, we’re looking at some very volatile market action. And therefore, I’d like to implement a special options trading tactic that’s specifically designed to profit off substantial market price swings. This strategy is called a “strangle.”

DIA

A “strangle” entails purchasing both calls and puts with different strike prices on the same underlying asset. For me personally, I don’t trust this market. I still think we have to re-test the January 2008 low, and for some miraculous reason, the markets were propped up yesterday despite the devastating news on BSC. Therefore, we’re currently holding the DIA April 114 Puts (DIA PJ), which we entered yesterday for $2.65. These puts are currently trading for $1.40, so this position is down from yesterday morning’s entry price. But what I’d like to do right now is to “leg into” a strangle position on the DIA by also purchasing the DIA April 125 Calls (DAW DU). As I write, these calls are trading between $2.19 and $2.23 per contract. Add this price to the entry point on our DIA April 114 Puts, and you have a total cost basis of $4.85 on our newly-established “DIA Strangle” position. And at this point, the concept is simple. No matter if the markets move aggressively higher or lower, we’ll own a position that’ll profit off this move. If the combined value of our DIA calls and puts exceeds $4.85, we’ll achieve a profit on our DIA basket. Plus, we also have the flexibility of selling off one side of the strangle position and letting the other side ride — thus maximizing our potential returns on both the calls and the puts. Leading into a Fed meeting that promises to spark a massive market reaction, I’d like to establish this DIA strangle position dated into April. And from there, we’ll be able to sit back and watch the massive price swings with a smile. In a market environment like this, owning a strangle on the DIA makes the most tactical sense, especially since we can ride each position into mid-April. Since we already own the DIA puts, then here’s the recommendation for the DIA calls.

PLAY: Buy the DIA April 125 Calls (DAW DU) at or under $2.25, good for the day. Since this position will be combined with our DIA puts, do not place any protective stop or sniper sell on it. I’ll manage it within the context of our intra-day trading alerts.

In other news, shares of CLHB opened the day lower after announcing they acquired privately held Universal Environmental. But as the trading session progressed, CHLB recovered and is now trading back in the green. The CLHB April 65 Calls (QPB DM) that we entered yesterday for $3.70 are now trading at $3.90, so maintain your $4.30 sniper sell target and be sure to lock in this gain if these prices trigger later today.

CLHB

And as always…

Lock and load!

Sincerely,

Bryan Bottarelli

Bryan Bottarelli
Editor, Bottarelli Research

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