This Direction-Neutral SPY Options Trade Ahead Of Powell's Speech Would've Doubled Your Money

BY Benzinga | ECONOMIC | 12/01/22 06:57 AM EST

Major Wall Street indices soared on Wednesday after Federal Reserve Chair Jerome Powell said the central bank may slow the pace of rate hikes as soon as December while also noting that bringing down inflation remained a long battle. 

The rally sent major Wall Street indices soaring with the SPDR S&P 500 ETF Trust (NYSE: SPY) closing the day's session higher by 3.14%.

Powell's speech was a scheduled event and if you had been following the financial press, you would have understood that market participants were keenly watching out for the speech. It was apparent that a major market movement was potentially on the cards.

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The Strategy: In such a case where huge market movement is anticipated, a good strategy to follow would be the "Long Strangle," which involves simultaneously buying a slightly out-of-the-money call and put options on an asset. 

If the market makes a significant move in either direction, one of the options would likely explode in value. The ensuing profit would, in most cases, more than cover the losses you made on the other option. Call options rise when the underlying asset price increases and put options gain when the asset price falls.

It is noteworthy that the maximum risk in this strategy is limited to the total price you paid for both options.

SPY Options: On Tuesday, a day before Powell's speech, the SPY closed at 395.23, according to Barchart data. As part of the Long Strangle strategy, you could have bought the 394-strike put option expiring on Dec. 1 at about its day-end price of $2.43 along with the 396-strike call option of the same expiry near its session-end price of $2.57. The total cost would have come to $5.

After Powell's speech on Wednesday, the SPY rally took the 396-strike call option to $11.89 towards the end of the session. The 394-strike put option lost value and ended the day at $0.06. The total value of both options stood at $11.95 -- a staggering 139% return. Ideally, in such a trade, it is recommended that you immediately close the positions and book your profit. Otherwise, you will see part of the returns diminish because of theta decay, or the loss in the value of an option, as you get closer to the expiry date unless the market continues to move in the desired direction.

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In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

Lower-quality debt securities generally offer higher yields, but also involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Any fixed income security sold or redeemed prior to maturity may be subject to loss.

Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.