Position Management for SPX Short Straddle

I suspect that when most investors make the jump from stocks to options, the most difficult issue for them to come to terms with is position management. With stocks, it is easy for an investor to reason that if a particular stock rises to a target price of X, he or she will take the profits and exit the position. By the same token, if the stock falls below Y, this means it is time to cut losses.

For options, the process becomes much more complicated. One of the complicating factors is certainly the potential for extreme percentage changes in an option position. It is not uncommon for an option to double in value for several consecutive days; alternatively an option can lose half of its value several days in a row.

Given all the questions I have received about how to manage options positions, going forward I have decided to share some of my thinking about position management using real-time case studies of options trades.

Let me offer up a taste of what I had in mind using a recent short straddle trade on the SPX that I first talked about on August 20^th in The Sideways Play.

First, while I did not go into detail about the rationale for the trade at the time of the original post, one of the technical factors I found appealing was the possibility of the 1000 serving as a consolidation point, with SPX potentially trading in a narrow range that was defined by 978-1018 at the time. The chart below shows that following the initial post (black arrow), SPX subsequently rallied as high as 1040, closing a little over 1030 on August 27^th. When SPX subsequently fell back below 1000 last week, there was reason to believe that the 1030 (closing) and 1040 (intraday) levels might serve as resistance. As described in SPX Short Straddle Still Hugging 1000 Level, the trade had started to yield some meaningful profits at this stage.

[graphic: StockCharts]

Recall from the original post that the short straddle will be profitable if the SPX option settles (on September 19^th) anywhere in the 950-1050 range. At the moment, with SPX in the upper quarter of the profit zone, the biggest risk is a breakout to the upside. I considered the risk to be reasonably well contained as long as SPX did not take out the August 27^th closing high of 1030.98. Leaving a little wiggle room, I set a mental stop of 1032. With yesterday’s close of 1033.37, therefore, I would close half of the straddle by buying back the at risk portion of the position, the calls. Ideally, this would have been done just prior to the end of trading yesterday or perhaps at today’s open.

The graphic below is a snapshot of the position as of yesterday’s close. The original premium was $5000 per contract. At the close of trading yesterday, the position could have been closed out for $3820, yielding a profit of $1180 per contract. This is down from a profit of $1490 a week ago today when the SPX was still hugging the 1000 level. The change in profitability in the past week has been largely the result of directional movement (delta) in the form of a 30 point jump in SPX more than offsetting the time decay at work over the course of the week.

[graphic: optionsXpress]

I see no reason to cover the short put side of the straddle, unless the SPX were to make a sharp move down. Using 1030 as resistance turning into support, one could plan to exit the puts if the SPX were to close below 1030. A lower SPX target might also make sense if I wanted to squeeze out some extra time decay (theta), from the short puts. If I were to take this approach, I would probably use a close (or perhaps intraday violation) of 1000 or below as my exit signal.

Note that in setting up my exits, I am completely ignoring the price of the actual options and prefer to focus on the underlying. In future posts, I will talk about a more holistic approach that encompasses not just the underlying, but also options prices, position Greeks and other factors.

For the record, the previous posts in this SPX short straddle series are:

1. The Sideways Play
2. SPX Short Straddle Still Hugging 1000 Level

An earlier two-part SPX short straddle case study may also be of interest:

1. Is the SPX Going to Stick Close to 900?
2. SPX Straddle Case Study Update

For additional posts on these subjects, readers are encouraged to check out:

• Straddles vs. Iron Butterflies
• One Approach to Volatile Sideways Markets
• The Options Opportunity Matrix