Strangle Pong

For the moment at least, it appears as if the S&P 500 index has encountered strong resistance at 1100 and strong support just above 1040. Assuming these support and resistance levels can hold up for another three weeks – and that is admittedly a large assumption – then the current market environment sets up nicely for what I like to call “strangle pong” with November SPX options. Essentially, this is an approach where one assumes range-bound trading and sells near-the-money options when the underlying approaches one end or the other of the trading range.

The graphic below outlines one way to approach this type of trade. Specifically, it involves dividing the trading range into three zones (which do not have to be of equal size, they just happen to be in the diagram): an upper end of the trading range in which one sells calls; a lower end of the trading range in which one sells puts; and a neutral zone near the middle of the range in which one takes no action (or perhaps sells both puts and calls.)

In an ideal world, the underlying bounces back and forth between support and resistance just like the pioneering computer game and the options seller captures a high premium each time the underlying approaches the end of the range. Once both puts and calls have been sold, a strangle is established, with the maximum profit and loss zone being defined by the target trading range.

The most important determinant of success in a strangle pong trade is the trading range of the underlying during the life of the trade. Of secondary importance is the volatility of the underlying, where increased volatility will increase the price of the options sold and work against the options seller. This is a position’s vega and is something I will address in future posts.

There are a number of ways on which position risk can be managed, not the least of which is to “buy the wings” (offsetting long put positions below SPX 1040 and offsetting long call positions above 1100) and convert this position into an iron condor. According to the strangle pong approach, right now, with the SPX trading a little below 1050, would be a good time to initiate the first leg of this trade by shorting some SPX 1040 puts. Let’s see how the market moves in the next week or so; I will revisit this strangle pong trading approach at that time.

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

• VIX Defining a Range Between 22 and 30
• Round Number Magnet Strangle
• ETFs, Leverage and Strangles

SPX Short Straddle Still Hugging 1000 Level

In many respects the ultimate pure play on declining volatility is a short straddle in which near the money puts and calls are sold simultaneously in hopes that the underlying will move very little prior to expiration. While this is largely a neutral directional bet, it is also a bet on declining volatility.

Two weeks ago today, in The Sideways Play, I outlined some of the logic and details behind what a short straddle trade would look like with the SPX at 1004. Two weeks later, with the SPX down a little more than five points, this trade is a winner. This trade is profiting from time decay (theta), which is currently at -1.20, meaning that all else being equal (i.e., if price, implied volatility and interest rates do not change), the position will gain $120 per day.

Of course, the other variables that affect the price of an option are in motion as well. Options traders use options Greeks to measure an option’s sensitivity to various influences on the value of that option, including the price of the underlying, the volatility of the underlying, time and interest rates.

Specific to the SPX short straddle, the increase in implied volatility (VIX) over the course of the past few days has worked against the options position. The Greek which measures an option’s sensitivity to changes in implied volatility is vega (not a Greek letter, but one that is counted as a ‘Greek’ according to options tradition), which estimates the change in value of an option that would result from a 1% change in the implied volatility of the underlying. In the two weeks, the VIX has increased 2.30 points and as the SPX straddle currently has a vega of 1.61, this means that the 2.30 point rise in the VIX has cost the position approximately $370 during the ten trading days.

While there are other factors at work on this short straddle trade, so far the main plot line has been a story of theta vs. vega, with time decay winning out.

The graphic below shows that a position which originally yielded $5000 in premium can now be bought back for $3510, which would lock in a profit of $1490. With the options expiring two weeks from tomorrow and time decay beginning to accelerate as we approach expiration, it will be interesting to see how this short straddle plays out.

For some related posts, try:

• The Sideways Play (includes profit and loss chart for original SPX short straddle trade)
• Straddles vs. Iron Butterflies

[graphic: optionsXpress]

The Sideways Play

The more dogmatic bulls and bears get about the markets, the more I usually begin to pay attention to the possibility of a sideways market. As is often the case, both bulls and bears can make compelling arguments to support their position – and even back them up with a convincing set of facts.

From a technical perspective, while the SPX has bounced more than 50% off of its bottom, there has been very little in the way of pullbacks during the ride up.

So here we sit at SPX 1004, with the major averages just a little below their recent highs and August SPX options set to expire at the open tomorrow. Still, it has been nine sessions since the SPX made its 2009 high of 1018. Finally, while volatility has been declining, the VIX seems to have found a floor in the 24-25 range.

With these factors, I am looking hard at selling some SPX straddles. The charts below show that a single contract SPX September 1000 short straddle (top chart) has a maximum potential profit of $5000, with a profit zone between 950 and 1050. Traders who might be interested in the SPX October 1000 short straddle (bottom chart) have a maximum potential profit of another 50% or so ($7530) and a 50% wider profit zone (from 925-1075) as well.

Short straddles will perform best when markets move sideways and volatility (vega) declines.

Of course, when short trades go wrong, they can get ugly quickly, so anyone looking to enter in a short straddle should expect monitor this trade closely and have all manner of exit strategies mapped out in advance.

Traders who are more risk averse will certainly be interested in checking out butterfly plays instead of straddles.

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

…and the two part SPX short straddle case study:

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

[graphics: optionsXpress]