The straddle: An options strategy for volatility

Although Cinderella and Prince Charming lived happily ever after, you cannot help but think there were some tremors along that road to happiness — and I am not talking about the potholes the pumpkin carriage may have encountered on the way home from the ball. Similarly, in the financial markets, there is a litany of potential shocks, from rising vacancy rates in commercial real estate to burgeoning government debt, that could lead to inflationary spikes — the likes of which we have not seen since the 1970s.

You could argue that the so-called “green shoots” supporting the view the recession has ended are simply the result of a wand-waving fairy godmother granting consumer wishes in the form of government largesse. And living in the fairytale atmosphere that is global politics, that may be enough. If this recession was really nothing more than a crisis of confidence, anything that simulates excess consumption may be enough to weaken the back end of the perfect storm.

The problem in the real world is that perfect storms are exactly that. You get the initial thrust, settle into the eye and await the back half. The way I see it, where we are right now looks suspiciously like the eye of a storm.

Technically speaking, you can’t help but notice that each new high in the U.S. financial markets has come on the back of steadily declining volume. Could this indicate a return to volatility once trading resumes in earnest this autumn?

Certainly, there is enough here to suggest taking some form of preventative action, in light of the historically strong gusts that traditionally accompany trading in September and October.

Some thoughts would include buying puts on exchange-traded funds that track major U.S. indices. In the U.S., you could look at Diamonds Trust (symbol: DIA; recently priced at US$95.06), which tracks the Dow Jones industrial average; or Standard & Poor’s depositary receipts (symbol: SPY; recently priced at US$102.94), which tracks the S&P 500 composite index. Both ETFs, by the way, have exhibited the same robust five-month rally on ever-declining volumes. With DIA, you could look at the November 93 puts trading at US$3.20; or consider the SPY November 100 puts trading at US$3.50.

Canada is no exception. No matter how smug we might be about the depth of the domestic recession and the balance sheets of Canadian banks, we will not escape any hurricane winds blowing up from the U.S. And since our financial markets have effectively traded in lockstep with those of our U.S. cousins, you can expect that ETFs such as iShares S&P/TSX 60 index fund (symbol: XIU; recently priced at $16.80) will feel the pressure in this “perfect storm” scenario. So, the cost of buying XIU November 16 puts at 50¢ seems like a reasonable cost for storm insurance.

Another approach is to look at leveraged ETFs that move inversely to the broader market. UltraShort S&P ProShares (symbol: SDS; recently priced at US$42.92), for example, offers 200% inverse leverage to the S&P 500 composite index.

In Canada, you have Horizons BetaPro S&P/TSX 60 Bear ETF (symbol: HXD; recently priced at $14.21), which offers 200% inverse leverage to the S&P/TSX 60 index.

The problem with inverse ETFs is that you have greater exposure to the downside. With a put option, the most you can lose is the cost of the put. Meanwhile, in a strongly rising market, inverse ETFs will decline with greater ferocity than a limited-risk options contract.

Finally, there is a real possibility that the government stimulus packages will instil the level of confidence necessary to keep the economic ball rolling. However, it is difficult to imagine that we will escape all of the potential potholes along the way under that scenario.

@page_break@In fact, a rising market with potholes may actually increase volatility, making strategies such as the straddle appropriate from a couple of perspectives. A straddle involves the purchase of a call and a put option on the same underlying security. So, the concern is not so much on the direction of the market but only that it moves more than the cost of the two options contracts.

For example, at the time of writing, you could have purchased the DIA November 95 calls at US$3.70 and the November 95 puts at US$4. The total cost for this position is US$7.70 per straddle. You would profit if the DJIA is above 10,270 (US$102.70 share price) or below 8,730 (US$87.30 share price) by the November expiration.

You would also benefit from interim increases in volatility, should we get exposed to some of those potholes discussed previously. A spike in volatility will push up the value of both the call and the put, which could make the DIA straddle profitable without breaching either end of the trading range. IE