A Low-Cost, High-Risk Trade on This Volatile ETF Could Lead to a Big Payout

Successful trading is as much about volatility as it is price trends. Many traders focus on prices and try to identify whether they are going up or down. If they are right they capture profits, but directional trades are actually only one way to make money in trading.

Short-term traders should be looking not only at the direction they expect prices to move, but also how fast they expect prices to move. A large move in a short amount of time could be more beneficial than that same move over a long period of time. This is because traders are almost always using limited capital, and if they can capture quick gains, they can redeploy their capital in pursuit of other opportunities. Volatility then becomes as important as price when considering short-term trades.

Among ETFs, one of last year’s biggest winners was also among the most volatile trades. The iShares Dow Jones US Home Construction (NYSE: ITB) gained 79.3%, including dividends, in 2012. On its way to that large gain, it made 12 different price swings of at least 5%. And six of those price swings in 2012 were at least 10% when measured from high to low.

In the past four months, ITB has been in a consolidation pattern. On the weekly chart, there are signs that the stock is setting up for another big move in the coming weeks.

ITB Chart

Bollinger Bands, a measure of price volatility, have been added to the prices in the chart. When the Bands are narrowing as they are now, volatility is contracting. Periods of contraction tend to be followed by volatility expansions. 

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In the middle of the chart, the Bollinger Bandwidth is shown as a black line. Bandwidth has been trending down for more than a year. A stochastics indicator of the Bandwidth has been included at the bottom of the chart to determine how low the Bandwidth has fallen. That indicator is at 0, and in the past it has always broken sharply higher after reaching this level.

These indicators show that volatility is expected to increase in ITB. When volatility in a stock or ETF increases, traders can use options strategies to benefit from a large price move. If the price goes up, traders who own call options win. When prices fall, traders owning puts win. A combination of calls and puts called an options straddle can win if the price moves up or down enough to cover the cost of the trade. This is the strategy that can be used with ITB.

The ETF has gained more than 160% since August 2011 and has not suffered a drop of 20% or more in that time. It is likely that ITB will retrace a portion of its large gain, and a 20% correction could be expected. On the other hand, with the market staring off the year strong, an additional 20% gain in price is also possible. Rather than betting on the direction of the move, this trade wins if a large move occurs.

ITB is trading at about $21.91, which means a 20% price move would be equivalent to $4.38. A combination of options that costs less than that could be profitable. Options with an exercise price of $21 expiring in April 2013 could be the best trade if ITB moves either up or down by at least 20%. The April $20 call option is trading at $1.90 and the April $20 put is at about $0.95 for a total cost of $2.85. That is the maximum loss on the trade.

If ITB goes up by 20%, the price would reach $26.29 and although the put would be worthless the call would be worth at least $5.29. That would be a potential gain of 86%. A 20% decline would see ITB drop to $17.53 where the call would be worthless but the put would be worth at least $3.47 and the position would gain 22%.That’s much less than the potential gain on the call; however, a decline of this size would probably push the ETF significantly lower, as downside momentum would likely accelerate, and the potential profit on the put therefore could be much greater. If ITB closes at any price except exactly $21, one of the options will retain some value and the loss will be less than the amount paid for the options.

This is a high-risk trade that benefits only if ITB makes a large move in the next three and a half months. Given the strong gain in 2012, a significant pullback seems likely and this trade would benefit. If that pullback doesn’t come and the gains continue, this trade could also deliver a gain.

Recommended Trade Setup:

— Buy an equal number of ITB April 21 Calls and ITB April 21 Puts for a combined price of $3 or less.
— Do not use a stop-loss. A trend in either direction will minimize the potential loss on this trade.
— Set initial price target at $4 on the combined position, which could come from a move to $25 on the upside or $17 on the downside. This would yield a potential profit of 33% in three and a half months.