January 4th, 2013
by Russ Allen, Online Trading Academy Instructor
Last week we continued with our example of XLF, an Exchange Traded Fund that represents a basket of stocks of companies in the banking, brokerage and insurance industries. Those businesses are sensitive to what happens with the “fiscal cliff” developments, so we can expect considerable movement in the near future. It also appears that there is a high likelihood of a good-sized increase in Implied Volatility, because IV is at a multi-year low.
We also noted that at around $16 per share, XLF’s price was at an important resistance/supply area, but one that had been tested before. So from both a technical and a fundamental standpoint, XLF’s price was unlikely to stand still at $16, and could go either way from there. As a measure of how far it could move, we noted that there was supply/resistance above at around $17.00, and support/demand below around $15.00, each a dollar away from current price
Note that on a monthly chart, the standard deviation for XLF was about $1.20 and the monthly Average True Range was $1.26. So a movement of $1.00 or more in a month would not be out character.
I talked about straddles and strangles as possible strategies in this scenario, and described the effects on each of them from price movement, time decay, and volatility changes, as measured by the Greeks.
This week let’s compare the straddle with the strangle in more detail. Here are the two alternative trades I proposed that we consider as of December 14, when XLF’s price closed at $16.00 even:
- Straddle – Buy 1 March 2013 16 call @ .53, Buy 1 March 16 Put @ $.67, Total Cost $1.20.
- Strangle – Buy 1 March 2013 17 call @ .17, Buy 1 March 15 Put @ $.31, Total Cost $.48.
With either trade, our proposed plan would be to hold the position for about a month, until the January 18 option expiration. The idea was that if price or volatility didn’t change by then, we would concede that we’d been proven wrong in our expectations and sell out. In that case we’d recoup a good portion of the time value we had bought, since the options would still have two months to go at that time.
Both trades initially would have net deltas of roughly zero, but those deltas would change fast as underlying price moves (i.e. both trades have large positive Gamma). So a big price movement would help them.
Regardless of price movement, both trades would benefit from an increase in IV, and be hurt by a drop in IV (they had a high positive Vega). They consist of nothing but time value, and time value is what’s affected by changing IV.
Best case for both positions would be a big movement in price (either way) AND a big increase in IV. Worst case would be where both price and IV remained static. In that case only time decay would have any effect, and it would be negative (both positions have negative theta).
The difference between the two positions is the degree of response to changes in price and IV. The tables below show this. Since the two positions had very different original costs – $ 1.20 for the Straddle and only $.48 for the Strangle – I’ve expressed the amount of profit or loss as a percentage of the position’s original cost, to make the two positions more comparable. Each cell in the table shows the estimated profit or loss as of January 18, 2013, for a given combination of XLF’s price and Implied Volatility at that time. Incidentally, these P/L estimates came from the Position Graph feature of Tradestation. They were obtained by creating a Theoretical Position for each trade; inputting the option prices as noted above; and creating a Position Chart for the trade. On the Position Chart, the future date and desired IV values can be entered, and the chart then shows the projected P/L at any underlying price.
Figure 1 below is for the Straddle trade (16 Call and 16 Put). Looking at the first row, first column we see a value of 66%. In this row, IV = 10%, and in this column Price = $14.00. This means that as of January 18, if the price of XLF is $14.00 and the IV of XLF is 10%, the Straddle will show a profit of 66% (which is a profit of $.789 on its original cost of $1.20).
Figure 2 is for the Strangle (15 put and 17 call). At a price of $14.00 and an IV of 10%, the strangle would show a profit of 109% ($.521 on its original cost of $.48).
In the two figures, each cell is colored red if the given combination of price and IV would result in a loss. Cells representing combinations that would result in a profit are colored on a scale from orange (slightly profitable) to green (very profitable). So each table is a crude heat map of profitability for the given conditions.
In both tables, we are starting from December 14, when XLF’s price was $16.00 and its Implied Volatility was 17%. Note these comparisons:
- If both Price and IV remain static, at $16 and 17% respectively, then both positions lose money. The Strangle loses much more (-59% compared to -31%).
- Even if price is stagnant at $16.00, both positions make money if IV rises above 25%, and the Strangle makes more at almost every price in that case.
- If IV is stagnant at 17%, but price moves either way by exactly $1.00 (to $15.00 or $17.00), the straddle about breaks even. The Strangle loses money (16% at $15.00 or 3% at $17.00).
- The Strangle is much more profitable for large movements in either price or IV or both. It also loses more from a lack of movement.
- The Straddle reaches profitability with a smaller movement in price or IV, but its profitability advantage disappears for larger changes in either.
In summary, we could say that the Strangle is a more highly leveraged bet on a price change and/or an IV increase. It costs less, but has a higher risk of loss. It also pays off much better, if things go as we expect in a big way. So if we are very confident, the strangle looks like a better bet; if less so, then the Straddle. A third idea would be to use the Strangle, but with a smaller position size to reduce total dollar risk. That would be my preference.
Finally, there is a less common strategy, called a Backspread, that can also be used in this situation. Next time we’ll talk about that one.