By: Steve Smith
As the trading range widens and with earnings on the horizon, instead of trying to divine the next direction use a straddle to brace for a big move.
When the S&P 500 Index finally pushed through to a new all-time high back on July 15 the question on everyone’s minds was “where to next?” There were bulls and there were bears, but I don’t think anyone expected the index to go sideways for an unprecedented 45 days without a 1% move, or remain within a 1.9% range during that time frame.
As that historically narrow range extended from days to weeks the question of where didn’t change much, but the new questions of when and how large became of equal import. The answer to the direction remained unknown, the when became increasingly imminent as time wore on and the size of the expected move kept expanding.
The notion being the longer a stock or index remains within a range, the ultimate resolution will have a move that is a function on the length of the range. The magnitude of the move based on time is sometimes referred to as the ‘measured move.’
The other byproduct of such a long and narrow trading range is that both realized and implied volatility of options tend to decline. In the case above, by mid-August the 30-day historical volatility in SPY declined to a record low of 4.9%, and the implied volatility of SPY options with 30 days until expiration hit a 9 year low of 10.2%.
Play Both Sides
This combination of low IV with the increasing likelihood set up a great situation to establish a straddle trade.
For those not familiar with the long straddle option strategy, it is a neutral strategy in options trading that involves the simultaneously buying of a put and a call on the same underlying strike and expiration. The trade has a limited risk (which is the debit paid for the trade) and unlimited profit potential. If you buy different strikes, the trade is called a strangle.
A long straddle option strategy is vega positive, gamma positive and theta negative trade. That means that all other factors equal, the option straddle will lose money every day due to the time decay, and the loss will accelerate as we get closer to expiration. For the straddle to make money, one of the two things (or both) has to happen:
- The stock has to move (no matter which direction).
- The IV (Implied Volatility) has to increase.
A straddle option strategy works based on the premise that both call and put options have unlimited profit potential but limited loss. While one leg of the straddle losses up to its limit, the other leg continues to gain as long as the underlying stock rises, resulting in an overall profit. When the stock moves, one of the options will gain value faster than the other option will lose, so the overall trade will make money. If this happens, the trade can be close before expiration for a profit.
In many cases IV increase can also produce nice gains since both options will increase in value as a result from increased IV.
In the situation described above in the SPY during late August with shares trading around 217.50 one could have bought a combination of the 215 put and the 220 call with September 16 expiration for a total $2.80 Net Debit.
This means the SPY would need to be below $212.20 or above 222.20 by expiration for the straddle to break even; an approximate 2.3% price move. The market did in fact drop some 2.2% on a single day on 9/09 to a low of $213.25. Not quite the breakeven point but remember the position can be closed prior to expiration.
And in this also thanks to the big spike in implied volatility, from 11% to 22%, the straddle could have been closed that Friday or Monday for a net credit of $6.70; a $3.90 or 139% profit.
When to use a straddle option strategy
Of course one needs to be disciplined and selective when applying a straddle. Straddles are a good strategy to pursue if you believe that a stock’s price will move significantly, but unsure as to which direction. Another case is if you believe that IV of the options will increase. In the SPY example above we had both items in our favor. But note, those situations may only present themselves a few times a year in both the broad market and individual stocks.
Right now with the SPY sitting within important support at $212 and resistance at $217.50 and the election and earnings season bearing down we may be setting up for another sharp move and jump in implied volatility.
Right now one can buy the October 212/217 straddle for around $3.10 net debit.
This means you would want the SPY to drop below $208.90 or climb above $220.10 prior to the October 21 expiration. A decline would likely bring an increase in implied volatility which would also be beneficial. And of course, you can always take the position off prior to expiration.
Here is what the risk graph looks like:
A long straddle option can be a good strategy under certain circumstances. However, be aware that if nothing happens in term of stock movement or IV change, the straddle will bleed money as you approach expiration. It should be used carefully, but when used correctly, it can be very profitable, without guessing the direction.
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