Tuesday, July 14, 2009

Round Number Magnet Strangle

The power of round numbers does not seem to receive a lot of play in investment circles. Sure, there is the psychological significance of an index or a stock crossing above or below a round number, but I am surprised that nobody ever talks about how to trade these.

Rather than look as round numbers as potential areas of enhanced support or resistance, I like to think of them has having a strong attractive power, almost as if they are large magnets. In some indices and stocks, prices tend to linger near round numbers for longer periods than a random distribution would suggest.

One way to take advantage of the attractive tendencies of round numbers is to sell options at or near that strike. Straddles, strangles, butterflies and iron condors would certainly be appropriate choices, but I have personal preference for strangles, with their wide maximum profit zone and simple construction/position management.

These ‘magnet straddle’ plays can utilize options of any duration, but maximum time decay (theta) is achieved in the last few weeks prior to expiration. In the graphic below, which is courtesy of optionsXpress, I show that anyone interested in selling an 890-910 strangle on the SPX can make a profit if the index manages to stay in a 40 point zone (880-920) during the last three days prior to expiration.

I feel obliged to mention that conventional wisdom says expiration week is too fraught with short-term uncertainty and gamma risk to be traded profitably on a consistent basis, yet I still think there are a number of opportunities where probabilities favor the experienced options trader.

Finally, if this trade sounds somewhat familiar, readers may be interested in checking out a similar straddle trade in Is the SPX Going to Stick Close to 900? from last December. With a VIX in the upper 50s when the original trade was discussed, the profit zone of 840-960 makes it look like a slam dunk winner by current volatility standards.

[graphic: optionsXpress]


Mark Wolfinger said...

As a general rule, I advise rookies options traders to avoid holding positions into expiration, due to enhanced risk.

That said, your idea has merit. If there is indeed any magnetic effect of a round number, then the probability of success changes - making the short premium play significantly better that it appears to be.

Jeff Augen's recent book discusses trading on expiration Friday, adding another voice to support your theorem that - under certain conditions - it's attractive to sell premium during expiration week.

Anonymous said...

I sold July 90 SPY strangles this morning.....

EyeDoc said...

Your graphic shows selling the 890 call and the 910 put.

Bill Luby said...

Thanks for catching the error, EyeDoc. I have replaced the original graphic with a new one that shows selling the 890 put and the 910 call -- albeit with a couple more hours of time decay off the table.



EyeDoc said...

You're welcome Bill.

vovor said...

Volatility News Flash

There were only 4 previous instances where the VIX:VXV ratio closed below today’s level.

All of them happened between May 15 2008 and May 22 2008.
The lowest close was seen at 0.8388 on May 22.
A local top took place at 1440 SPX on May 19 and closed with its RSI(2) at 96.12 with VIX bottoming 12.11% below its 10-day SMA.
SPX then lost 6.8% over the next month and ~16% over the next 57 days.

Also, on December 21 2007, VIX:VXV closed at 0.8591. Its RSI(2) was at 0.37. VIX was 16.23% below its 10-day SMA, with its RSI(2) at 3.47.
A local top took place two trading days later at 1497 SPX when its RSI(2) was at 95.60.
SPX then and lost 15% over the next month.

VIX:VXV ends the day at 0.8458 (-3.23%) with its RSI(2) at 2.35
VIX ends the day at 25.02 (-4.90%), its lowest close since Lehman went down.
It is 11.21% below its 10-day SMA. Its RSI(2) stands at 3.75.
SPX closes at 905.85 (+0.53%) with its RSI(2) at 90.21.

If you don’t mind, Bill, I have two questions:
- are you still a fan of RSI(2) or have you switched to RSI(3)/RSI(4)?
- are these numbers going to make your short term bearishness come back faster than a horse pricked by a sea urschin? The question considers the after-hours pop.

Bill Luby said...

Thanks for the excellent research, vovor. You may have save me a post.

Regarding your questions:

1) I have long been a fan of RSI (2), though I was a little bit concerned when it got so much attention last year. I also use RSI (3) and rarely use RSI (4) -- mostly as a matter of habit.

2) The INTC earnings report clearly has many of the shorts scrambling to cover after hours. My bias flipped to bullish yesterday, but not aggressively so. I'd like to see how the market reacts to a bunch of other earnings (including JPM, C, BAC +/- GE just this week in the financial space) and the full calendar of economic data releases before I chart a new course with any degree of conviction.

The VIX:VXV ratio has a solid track record and is clearly a bearish signal right now, but while the bulls are still gathering momentum, I don't see any reason to bet against them at this juncture.



vovor said...

Thanks Bill for your quick reply.
I'll be paying a close attention to SPX/VIX/VIX:VXN and their RSI(2).
FWIW, today we're entering a very important time period with several major turn dates.
As I know you're interested in emerging markets, I suggest you read BNP Paribas's Quant Research Note entitled The Chinese Stock Bubble: Watch For "Critical Level Around July 17-27, 2009"


Anonymous said...

Bill, can you explain WTF is going on with vix today?! Is it OE shenanigan? I mean from 10AM vix pretty much go up with the market and just stops at 25.. Now the market is shooting back up again, vix simply just dead, not droping at all... weird...

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