Strangling Profits From EEM’s Low Volatility

One emerging market ETF has been stuck in a rut for the past three years, and an institutional options trader stands to make $900,000 if it stays in that rut until March.

It’s easy to make money if an ETF goes up, but you have to use options to profit from it going sideways. That’s just what one options trader did on Tuesday in the iShares Emerging Markets ETF (EEM | B-95).

How The ‘Strangle’ Works

In selling the $45 strike call option, our trader thinks EEM will be below $45 at option expiration in March. In selling the $35 strike put option, our trader thinks EEM will be above $35 at that March option expiration. By selling both options, which make up an option “strangle,” our trader is saying EEM will be between $35 and $45 at March expiration.

By looking at EEM’s performance over the past three years, you can see why this option trader thinks it will be between $35 and $45 next March:

During the past three years, EEM has never closed below $35 (accounting for dividends), and has closed above $45 (accounting for dividends) exactly once. And since EEM was trading at $40.64 when this trade was executed, it’s about as far from breaking out of that range as it can be.

Our trader stands to make a maximum of $900,000 if both options expire worthless, which will happen if EEM is between $35.00 and $45.00 at expiration, but losses would be substantial if EEM makes a big move and breaks out of this range:

Selling an options strangle is a speculation that volatility will remain low. After looking at EEM’s three-year price chart, it seems likely EEM will stay in its recent range—volatility will remain low—but if volatility should increase significantly, leading EEM to break out, then losses will be substantial.

If at option expiration, EEM were to drop to $30.00—a level last seen in April 2009—then the loss per share would be $3.20; if EEM were to drop further, the loss would increase. If at option expiration EEM were to rally to $50—a level last seen in May 2008—the loss per share would be $3.20, and the loss would increase as EEM continued to rally.

Profiting from Range-Bound Prices

Options allow for payoff profiles that can’t be achieved any other way, and selling strangles can be a great way—really the only way—to generate a profit when an ETF is range-bound. But they’re not without risk.

For the retail ETF trader, a better way to sell an options strangle is to do it against ownership of the underlying shares, a little bit like a covered call.

By selling a covered strangle, you’ll have your shares called away if they rally above the strike price of the call option. You’ll also be committed to buying more shares—at a discount to where they’re trading now—if the price falls. But if you still like the prospects for the ETF, then you might be happy to buy more at that lower price.

And if the price of your shares doesn’t move? Then you’ll pocket all that option premium.

At the time of writing, the author didn’t own a position in EEM. Follow Scott on Twitter @ScottNations.