There appears to be three major, seemingly conflicting factors at play in the financial markets from which options traders could profit handsomely.
Front and centre are macroeconomic issues in the U.S. In particular, there is the so-called “fiscal cliff” of rising income taxes and planned federal spending cuts that are set to begin on Jan. 1, 2013. This issue will dominate headlines for the rest of the year until a solution comes to pass.
The second factor is the eurozone, which remains a loose affiliation of European states with conflicting agendas. You need to think about the eurozone’s problems as if they were those of the U.S. on steroids. Nothing good is likely to come out of this part of the world for some time.
The third factor is investor complacency, which seems oddly out of place, given the current state of affairs. For example, the Chicago Board Options Exchange’s volatility index (symbol: VIX), which measures the level of volatility being implied by premiums on S&P 500 composite index options, continues to track along the bottom of its trading range. (Volatility is how the options market quantifies risk.) You would think that, given the uncertainties and potential repercussions from any of the other factors, volatility would be higher – as much as 30% higher, in fact.
The point is: low volatility opens the door for long option strategies that would profit should events take a wrong turn – particularly if the pending uncertainty leads to a crisis in market confidence.
To that end, you may want to introduce your clients to the benefits of “long straddles.” A straddle involves the purchase of both calls and puts on the same underlying security.
The straddle is a non-directional trade that profits from a significant move up or down in the underlying security. Put another way, it is not a matter of which direction the underlying security goes; only that it moves by a greater amount than the total cost of two options.
The straddle also can profit should the underlying security gyrate up and down more dramatically than it has in the recent past. In that scenario, volatility would increase, which would push up the value for both the call and the put.
With VIX at the bottom end of its trading range, options on the S&P 500 are not particularly expensive – all of which enhances the profit potential and the portfolio benefits inherent in straddles.
Consider five-month, at-the-money straddles on the S&P 500 depositary receipts (symbol: SPY), which is an exchange-traded fund that mirrors the S&P 500 while trading at 10% of its value.
SPY recently traded at US$141.35. At that level, both the SPY March 140 calls and SPY March 140 puts were trading at US$6.20. The total cost for an SPY March 140 straddle would be US$12.40 (that is, US$6.20 for the call + US$6.20 for the put).
Another way to look at the straddle is to think about it as the implied trading range for SPY between now and the third Friday in March 2013. Ostensibly, if we were to add the $12.40 cost of the straddle to SPY’s US$140 strike price, we have an upside target of $152.40. Similarly, if we subtract the US$12.40 straddle cost from the US$140 strike price, we have a downside target of US$127.60.
That, by the way, equates to an implied trading range of 1276 to 1524 for the S&P 500 over the next five months. The index has been at around 1400 for much of the past few months.
To that end, the straddle makes the most sense if you believe that the S&P 500 is likely to breach either end of that implied trading range over the next five months. That said, the straddle also can profit if the index moves significantly within that range over the next five months.
The fact that you can buy a straddle for your clients when traders are most complacent also adds a measure of insurance to your clients’ portfolios. The straddle will be profitable should the market fall sharply, offsetting some of the losses for the more traditional assets in your clients’ portfolios.IE
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