Quinn’s Brain, aka QBrain

In the stock market, everyone is getting a beat down lately. I have been thinking about what I can do to take advantage of the situation, and what strategies I could employ that benefit from increased volatility.

If you do not expect the stock market to stand still, but you have no clue which direction the mongrel hordes are going to run, then a straddle is an appropriate option strategy to take advantage of the volatility you expect in the market, with limited risk, and no idea which direction the market is going to move.

A straddle is when you buy one put option (someone will buy the underlying stock from you at the strike price) and one call option (you will buy the underlying stock at the strike price). Typically, a strike price at the money is picked, and risk is limited to the cost of purchasing the two options.

For example, lets say you what to execute a straddle on XYZ which is trading at $100. A call with the strike price of $100 is selling for $1, and likewise, the put with the same strike prices is also selling at $1. The $1 is the price of the option for 1 share, and options are sold in units of 100, so 1 straddle of XYZ at $100 will cost $200. You make money if XYZ goes up above $102 or down below $98, and you lose money if XYZ lands somewhere in between. The worst case is if XYZ stays at exactly $100, then both options expire worthless, but it is likely, even when you don’t make money, the loss will be less then $200, because one of the two options will likely be in the money.

Now that you understand how straddles can make money, it is easy to see why the more chaotic the market, the more likely they will be a profitable strategy. But there are two sides to every story.

Options, like stocks, are a zero sum game. Someone has to put money into the market for someone else to take out money from the market. Placing a straddle make you an option consumer, someone who wants one of the options to expire in the money. But on the other side is the option writer, who wants to write an option that will expire worthless. How does the option writer affect the potential profitability of option buyer? By adjusting the price of the options. The option writer knows that the more volatile the market it, the more likely there will be a move big enough that the option he is writing will expire in the money, which costs the option writer money and make the option buyer money. As volatility increases, the price of the options increase.

Here is the strategy I tested. Every month, I bought 10 straddles at the money rounded down on the first trading day after the option expiration date for the following months expiration. This gives me a position that expires approximately one month from the purchase date.

The table is not the easiest thing to read, but let me summarize. There are two years worth of data there, and the first year there was a profit of $5,760 while the average investment was only $4,162.50 and the max was $8,450. This was a good year it seem for the straddle strategy. The second year there was a loss of $10,055 with an average investment of $6,607.08. This was not so good of a year.

That bring us to the current market. What is we had placed a Oct 08 straddle at a strike price of 121. This last 3 weeks has seen the markets loose over 25%. Following the same strategy, the straddle that is currently in play would have cost $8,300 to place and would be up $23,990.

While that is excellent if we had been actually following this strategy, what does that mean if we wanted to start following the strategy going forward? Obviously the market will either continue going down, or it will bounce back up, but it is unlikely to go from such high volatility straight into no volatility. Can this strategy make money before the markets calm down?

Looks at the prices for the Nov 08 options, to follow the strategy would cost more then $16,000 to place the straddle. The extreme volatility has caused the option prices to shoot up to such a level, that for the straddle to pay off, SPY would have to more 20% in either direction in under one month. While it happened that SPY has dropped over 25% this month, the cost to enter was only $8,300. The return on October straddle looks very good, but the reward does not justify the risk for the November straddle.

This is only one straddle strategy, a fairly simple and straight forward implementation. I will not be using this strategy in the current market, but I will keep my eye out and continue to do research looking for a better time to apply it.

Posted on October 11th, 2008 under Finance • RSS 2.0 feed • Leave a response, or trackback