Combining CFDs and options to make money in a stagnant market
Readers who are only familiar with stock trading and not with the world of CFDs and options might be under the mistaken impression that it’s only possible to make money if the market goes up.
This is of course not the case. With short CFDs it is also possible to make money if the market goes down (provided the trader correctly predicts the direction of the market movement). And with a combination of CFDs and options one can indeed make money in a stagnant market. What follows is a brief explanation of this technique.
Fig. 11.19(a) below is the risk/reward chart of a typical long CFD trade. If the price goes up, the owner makes money. If it goes down, he or she loses money. If it remains stationary no money is lost or made.
Fig. 11.19(a)
If the CFD owner believes the price of his CFDs are going to remain relatively stable for the foreseeable future, e.g. the next 1-3 months, he could decide to sell call options to generate income without selling the CFDs.
There are two possibilities in this regard. He could either sell ATM (At The Money) calls or OTM (Out of the Money) calls.
At The Money calls options will bring in higher premium, but they do not allow the CFD owners to profit from price increases of the underlying stock, currency or commodity. The risk/reward chart for the trade looks like this:
Fig. 11.19(b)
If the price of the underlying goes up, the CFD owner will only benefit from the premiums of the call options, while if it goes down the normal downside risk of a long CFD will be present.
The second alternative is to sell OTM call options. This would generate a lower premium, but allow the CFD owner to benefit from upwards price movements in the underlying to the level of the strike price of the options. Fig. 11.19(c) below shows the new risk/reward payoff.
Fig 11.19(c)
The reader will immediately notice that the maximum profit of this trade is significantly higher than when selling ATM call options, since it is allowed to benefit from price increases in the underlying security up to a certain point.
The profit when the price remains stationary is, however, lower than in the case of an ATM option and the loss in a downward movement is higher with an amount equal to the difference between the premium of the ATM and OTM call options.
Using put options
There is another way to make money in a stagnant market, this time using short CFDs and put options.
A short CFD combined with writing a short put option will create the following risk/reward scenario:
Fig. 11.19(e)
If the price of the underlying remains at 100, the trader will make a profit equal to the premium he or she received for the put options.
Once again this can also be constructed with OTM put options, to provide a higher profit ceiling in case of a downward movement, but lower profits if the price remains stagnant or goes up.
Fig. 11.19(f)
Readers will notice that the higher maximum profit comes at the price of lower profit if the price remains at 100 or goes up above 100.
