When market direction is uncertain, but conditions are anything but calm, what’s an option trader to do? Two strategies that might fit are longer term straddles or strangles.
I’ve been blogging about the CBOE Volatility Index (VIX), often nicknamed the "fear index" for years now. Lately the VIX’s movements have been all over the map: the VIX moved from relative calm, stable levels, then spiked as concerns over the European debt crisis prompted fears. Tomorrow’s move is anybody’s guess, but one thing is clear: the market’s direction is uncertain, conditions looks volatile, but even volatility can’t be counted upon as constant.
Today’s upward move, (as of this writing) in the S&P 500 index (SPX) up 2% has driven the VIX down a whopping 9.72% to 27.96, made me think about these two option strategies – straddles and strangles. The two questions that came to mind "Is today’s news the end all to the European debt crisis?" and "Will there be more market moving headlines to come over the next couple of months?".
It is not often that I would think about longer term straddles and strangles, 3 to 5 months out in time, the market conditions have to be favorable. Hold on, let’s introduce in generic terms what is involved with the straddle and strangle strategies before we get into the expiration periods. (Be forewarned: longer term straddles and strangles are tougher to pull off profitably than they may seem). (Now’s a good time to mention:straddles and strangles are multiple-leg options strategies involving additional risks and commissions,and may result in complex tax treatments. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.)
To start with, the long straddle:
- Stock at 50
- Buy to open a call, strike price 50
- Buy to open a put, strike price 50
Generally, the stock price will be close to the strike price used, and both options will have the same expiration month. You’re hoping the underlying stock will make a big price move in either direction, breaking even at two points: Strike 50 plus the net debit paid or minus the net debit paid.
If the stock shoots up, your potential profit is unlimited. If the stock goes down, potential profit may be substantial but limited to the strike price minus the net debit paid.
The max risk for the straddle is limited to the net debit paid for the trade.
Sounds simple and appealing, right? Well, not exactly. Since both options are at-the-money long options, they’re highly vulnerable to swings in the Implied Volatility (IV) component of the options price – also known as Vega. Vega risk is especially high in longer term At-The-Money(ATM) and just Out-of-The-Money(OTM) option contracts because they have more time value for IV to mess with than their nearer-term counterparts. That also means they’re likely to both be expensive and that expense increases the max risk. That means you need a really sizeable price move in either direction before the trade gets into profitability territory. (That price move needs to be big enough to clear the net debit paid PLUS the round-trip commission of $12.50)
The same dynamics impact the LONG STRANGLE, which consists of the following setup:
- Stock at 50
- Buy to open a call, strike price 52.50
- Buy to open a put, strike price 47.50
Just like a long straddle, both options will have the same expiration month, and the potential rewards are the same. Also, the max risk for the strangle is the same, in that, it is limited to the net debit paid for the trade. But you’ll notice one key difference between the two plays: a strangle separates the strike prices for the two legs of the trade. Because you’re buying 2 OTM options versus ATM, that difference tends to make the trade more affordable to enter. But, like everything in the options market, there’s a tradeoff: because you’re dealing with an OTM call and an OTM put, the stock will need to move even more significantly in one direction with a strangle before you profit.
Besides expecting wild price swings in the market, another reason someone would do a longer term straddle or strangle is because they thought the IV was low now and would be going higher over the life of the trade. So for underlyings think of industries and stocks that are in the news today and maybe pick an index or something that tracks that industry. You may want to do a trade in a larger market following index if the concentrated vehicles are too scary for your risk tolerance. Note: If you do decide on a particular stock make sure you know when earnings are planned to be announced and work that into your forecast. Bottom line, your general forecast should be that implied volatility or VIX will go back to its previous levels if you are considering longer term straddles and strangles as a possible strategy.
It is not often that market conditions make longer term straddles and strangles worth a look, but then again market timing is everything.
TradeKing’s Options Guy