Another arrow in the investor’s quiver

If you trade the XYZ straddle, you are not concerned about direction; only in the degree of the move, either up or down. Being long or short on the XYZ 50 straddle is a bet that the volatility, or trading range, being implied by the straddle is either too low or too high.

The options market provides information on the expected trading range for a broad cross-section of stocks and the market overall. And although this may not prove to be an accurate trading range — i.e., the market may move above or below the current range over time — it does provide an unbiased frame of reference with which to fine-tune investment decisions.

With that in mind, it might be useful to look at some recent data on the U.S. stock market. Specifically, I would draw your attention to options on the S&P 500 depositary receipts (symbol: SPY), which, at the time of writing, was trading around US$126.

Given that price, let’s look at the SPY December 126 straddle, which was valued at US$26.75 (Dec 126 call = US$12; Dec 126 put = US$14.75). These options expire on Dec. 22, 2012, which is about a year away.

The upside boundary for the implied trading range is US$152.75 (US$126 + US$26.75 = US$152.75), while the downside boundary is US$99.25 (US$126 – US$26.75 = US$99.25). SPY is an exchange-traded fund offered by Boston-based State Street Global Advisors that trades at one-tenth the value of the S&P 500 composite index. As such, the implied range for the S&P 500 composite index would be 992.50 on the downside and 1527.50 to the upside.

Although this may seem like a large trading range, it reflects the market’s longer-term view (i.e., of more than a year) about the uncertainty surrounding the so-called “risk on/risk off” trade.

The implied trading range provides another tool to employ in making investment decisions. An implied trading range does not reflect so-called “Black Swan” scenarios (e.g., the breakup of the European Union; the collapse of the EU banking system; stress-test failures for “too big to fail” U.S. banks), but it does reflect statistically relevant developments.

Taking that position a step further, you will note that the implied trading range on any stock is being framed around the current stock price, which, statistically, is believed to be the underlying stock’s fair value. Most investors or analysts of the technical or fundamental persuasion would have issues with that point of view. In fact, if the current price was the fair value, what would be the inducement either to buy or sell?

One way around this question is to look at a stock or index value over longer time frames — say, a 50-day or 200-day moving average. You would then assume that the moving average was the fair value and that the day-to-day fluctuations represent noise.

At least, the longer-term moving average takes into account statistical concepts such as mean reversion and fits well with technical factors such as support and resistance.

If we were to frame the implied trading range around a moving average, we would alter the underlying stock price. For example, the SPY 200-day moving average at the time of writing was almost US$125 a share, slightly below the current price, while the 50-day moving average was around US$121.

With the current price above the moving averages, we could say the trading range implies a slightly bullish bias with an upside limit.

Certainly, the implied trading range is not meant to replace well thought-out technical indicators, but it does add another arrow in the investor’s quiver.

And that is the bottom line: the implied trading range is a tool, not a solution.  IE