Strategies for a Sideways Market

The Wall Street Journal

Stock investors can be forgiven if they feel like they have traveled great distances to go nowhere. Since the beginning of the year, the Dow Jones Industrial Average has been up as much as 7.5% and down as much as 6.7%, only to finish July virtually flat for 2010.

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A range-bound market doesn't have to be an unprofitable one, however. There are three trading strategies that, when used properly, can help investors make money in the short term.

One of them involves short selling shares of leveraged exchange-traded funds. These funds are designed to magnify by two or three times the daily movements of an index such as the Standard & Poor's 500-stock index. A 2X leveraged bull fund, for example, is supposed to double a positive daily move, while a 2X leveraged bear fund should double a negative move.

Note, however, that leveraged funds won't double or triple an index's performance over a longer period of time. In fact, since the funds are reset every day, holding them for a long time can result in a loss even if the underlying index moves up. For instance, if a fund that aims to double a market's return were to gain 10% in one day, then lose 9% the next, it would lose 1.6% over the two days rather than gaining 0.2% by doubling the return on the underlying index.

Investors can use this quirk of compounding to their advantage, says BNP Paribas strategist Bouhari Arouna. By short-selling a bear and a bull fund, betting that their values will fall, they can capture the drop in the ETF's value resulting from daily compounding in a choppy market.

For instance, investors who shorted the Direxion Large Cap Bull 3X ETF (NYSE: BGU - News) and its opposite, the Direxion Large Cap Bear 3X fund (NYSE: BGZ - News), made nearly $1,100 on a $10,000 investment from Dec. 31 to Aug. 2, well above the $96 an investor would have made by owning the S&P 500 index itself.

The strategy is risky, for sure. The same trade lost $241 from June 21 through July 2. Shorting ETFs also can be expensive.

A sideways market also is ripe for a "covered call" play. The gist: You sell a call option, or the right to buy a stock at a certain price, on a stock in your portfolio. If the stock stays range-bound, the premium you earn from selling the call can provide a significant source of income, while mitigating some of the loss should the stock price fall.

For instance, shares of 3M Co. (NYSE: MMM - News) recently fetched $87.63, near their 52-week high of $90.58. By selling an August call with a strike price of $85, you can collect a premium of $3.05 per share, or 3.5%. If the stock remains range-bound, you keep the premium, which would protect you if the stock falls to $84.65. The downside? If 3M stays above $85, you will have to sell the stock—even if it moves higher.

Investors with a strong stomach might also consider a paired-options trade known as a "strangle," a wager that a stock or index will trade within a certain range for a period of time.

Say you believe the S&P 500 will stay below its post-Lehman high of 1220 and above its 52-week low of 979 reached on July 2. When the S&P 500 was at 1125 on Aug. 5, you could have sold a December 2010 1200 call option and a December 2010 1000 put option. The call obligates you to sell the S&P 500 at 1200 if it hits that level before Dec. 18, while the put obligates you to buy the index if it falls below 1000.

Meanwhile, you collect a premium of nearly 5%, says Mitchell Revsine, a derivatives strategist at UBS Equity Research, who is recommending the trade to institutional clients. (UBS expects the index to finish the year at 1150.) If the S&P 500 trades outside the target at expiration, the premium covers the first 50 points or so on both sides before the trade loses money.

Be warned, though: If stocks break out of that range the loss could be steep. If the S&P 500 trades below 950, you will end up owning the index—even if it drops another 200 points.

In a sideways market, like any other, you have to take risk to make money.

Write to Ben Levisohn at ben.levisohn@wsj.com

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