SPY – Back in the Straddle

by riskreversal September 30, 2016 3:13 pm • Education

I concluded today’s MorningWord (Wake Me Up When September Ends) with a comment that events in the next few weeks might spark some market volatility (one way or the other) and how the options market in S&P 500 etf (SPY) options are not pricing in a whole heck of a lot of risk between now and Oct 21st expiration. My thought was that some of the themes that caused volatility this week might continue into Oct. First there is the next presidential debate on Oct 9th. Then there is the ongoing plight of Deutsche Bank, something will need to be resolved sooner than later on that situation. And obviously the start of Q3 earnings season could break us out of the recent trading range one way or the other:

(Oct) Could be a volatile month to say the least, yet options premiums seem fair, to possibly cheap. To add a little context to that statement, with the SPY at $215, the Oct regular 215 straddle (the call premium + the put premium) is offered at about $4.50, or about 2% of the underlying etf price, seems cheap-ish. If you bought the implied move in the SPY between now and Oct 21st expiration, you would need a move above $220.40 or below $209.60 to make money.

As we used the at the money straddle to predict implied movement, we want to quickly talk about the strategy of buying straddles and why it may not be a high probability bet if simply done on its own. The straddle is pricing in an implied move in both directions, combined. What that means is that people willing to bet directionally, by buying the at the money call, or put, are basically faced with 50% odds of either making money, or losing money. And equal odds of losing all their money, or doubling their money. That assumes the implied move is realized, but only having a 50% chance of being right on direction.

When you combine both the call and the put, you haven’t picked a direction, but you’ve doubled the move you need in either direction than had you bought just the call or the put (movement to the implied move is simply the break-even on the straddle, where in the case of the call or the put, would have been a double, or worthless).

So the way traders combat that when they buy what they feel is an under-priced straddle is they scalp stock against the options position. What that means is when the stock goes higher, the deltas of the position increase, allowing stock to be sold against the long straddle. When the stock then goes lower, the deltas of the position decrease (or go negative), allowing stock to be bought back. Do this enough times before the straddle expires, and you can make more money than the straddle cost. And you can do it in a way where you never really have delta risk (this is referred to as delta neutral trading and is how options traders manage long vol/gamma positions).

There’s another way to “scalp” without sitting in front of a computer buying and selling stock. And that is to spread the long calls on strength, and spread the long puts on weakness (selling either a higher strike call of the same or different expiration, or on the flip-side a put). This offers the ability to take off risk of the original premium spent when the underlying makes moves in one direction or the other (or both).

In any case, the odds of simply buying a straddle and making money are slim, no matter how low the volatility is and how mis-priced you think it may be. It needs to be managed when the underlying makes moves before expiration.

So here’s the current at the money straddle in the SPY:

SPY ($217) Oct 21st 217 straddle, $4.50 or about 2%

  • Buy 1 Oct 217 call for $2.25
  • Buy 1 Oct 217 put for $2.25

Break-Even on Oct expiration:

Profits: above 221.50, up 2%

Losses: below 212.50, down 2%

Currently the SPY is right at its 50 day moving average ($216.90). And that could act as both a magnet over the next few weeks as well as a point the etf makes big moves through on breaks above and below. That’s why there are 2 ways to skin the cat on a straddle. You could sell it, and hope for a pin, and sweat out the moves in either direction. Or you could buy it, hope for big moves in either direction and hedge it accordingly by either buying or selling stock or spreading the original options on those moves.

One year SPY chart with uptrend and break-even for straddle.  Whats interesting about this chart to me is that the break-even on the upside obviously implies a breakout to new highs, while the break-even on the downside is at clear technical support which was the July breakout level and is very near the up-trend from the 2016 lows:

SPY 1yr chart from Bloomberg