With the looming threats of higher taxes and interest rates next year, portfolio managers are beginning to lower their estimates for what the S&P 500 (SPX) will earn going forward. While the pace of the recovery in key economic data, earnings, and stock prices was definitely V-shaped for a while, it’s starting to look like a deceleration is occurring and this was recently summed up by boutique investment bank Stifel Nicolaus when they downgraded Berkshire Hathaway on their view of a “blah-shaped recovery.” This doesn’t portend a double-dip or deflation or that nasty stagflation, but it doesn’t spell meaningfully higher stock prices either. Recent updates on the Standard and Poor’s website have full-year 2010 S&P 500 earnings lowered to $73.32 while many firms were looking for $80+. At an index level of 1,050, which is where it looks like we are headed again next week based on today’s price action, that’s a P/E multiple of just over 14. And that’s not expensive—if the economy were still on a V-trajectory. But since that path is now in doubt, stock prices are more likely to drift around these levels than be bid up in anticipation of better times ahead.

Trading strategies for a sideways market

Is the slowdown for real? It depends on how you look at it. Economic data may be slowing its pace of recovery and that may affect earnings and stock prices. But what really matters is perception here. If the mood on Wall Street changes to, “Let’s wait and see…” from, “When in doubt, we still have to buy,” then stocks are due to trade sideways. Whether you call this market a cyclical bull or merely a big rally in a larger bear market, one way that many options traders will be taking advantage of a slowdown in the advance of equities is with option spread strategies that sell the swings in optimism and pessimism. Let’s look now at some possible ideas to play the likely ranges. If you believe that the S&P will be hard-pressed to get above a certain level for the next two to three months, then sell call spreads just above that level. Here are two possibilities: 1) If your bear level is 1,100, you might consider selling call spreads above 1,120. On June 24, we noted that the S&P was very vulnerable to further downside from 1,080 since rejection at the 20-week moving average near 1,130 that week and a bearish cross of 10- and 20-week averages. A good bear case can be made that the index will not likely get above 1,120 in the next few months. For that, option spread sellers will look at selling the SPY August 112/114 call spread for 50 cents, or the same September spread for 70 cents. 2) If your bear level is higher, say at 1,150, then you might consider waiting for a rally to sell the SPY 116/118 call spread. On the downside, where do you think support will hold on the S&P? It helps to have a good idea of both the chart and the fundamental valuation of the market to make decisions. On June 30, as a follow-up to our June 24 bearish call, we identified a strong support target at 1,015. The market bottomed at 1,010 the next day. Here are some ideas for selling put spreads on the market breaks: 3) If you believe that a test of at least 1,020 is likely, but that it will hold, then waiting until the index drops below 1,040 should provide good opportunities to sell the August or September SPY 100/98 put spreads. Right now, the August spread is trading for only 30 cents and the September one for 40 cents. There is no reason to rush and sell these spreads now because as the market looks poised to test lower next week, you will get much more premium for these strategies—especially as the VIX spikes higher on escalating fear. 4) If your downside target level is closer to 980 on the S&P, then good opportunities will come to sell the 95/90 put spreads for those who are patient and quick on the draw when the chance comes. Any dip below S&P 1,000 will likely be swift and violent, with a potentially gut-wrenching plunge and then snap-back all in the same day. In that scenario, the VIX could vault as high as 40 and those ready with their orders will be rewarded with relatively high premiums on spreads.

Legging into iron condors

You can think of these approaches to trading a sideways market as “legging into” an iron condor. By waiting until the market rallies to likely resistance or drops to support, you can earn more premium from the option spreads you sell. Remember, the idea of an iron condor is that you have a likely trading range in mind, but you are not sure which was the market is going to trend within that range so you sell both spreads at once to lower your overall risk. By legging into an iron condor, you are acting on the assumption that you have a good idea of how the market will act and you believe you can time the swings up to resistance and back down to support, or vice versa. But overall, if you are confident in your levels and range boundaries, you may not mind missing one side of the condor.

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