An Options Strategy for Volatile Times

Since the second half of July 2007 we have experienced increased volatility in worldwide equity markets when the credit crisis emerged to the surface with full force. Equity prices dropped sharply until the middle of August, followed by a strong rebound that lasted until October when the highest level of the S&P 500 index was reached. Since then, prices have been dropping with some attempts to positive corrections. This continued landscape of uncertainty is posing challenges for every style of investor. Being right is already difficult enough, but the cost of being wrong can be so much higher with high levels of volatility in the market.

Every financial landscape however also lends itself to new opportunities and strategies, and in this article I will describe an option strategy that may occasionally work very well in the market environment that we are experiencing these days. I am referring to the possibility of taking a long position in a so called straddle or strangle on an index. For readers who are less familiar with option terminology, a straddle is an option combination of both a call option and a put option where the strike price and maturity date are the same. A strangle is a combination where the strike price of the call option is higher than the strike price of the put option.

The interesting thing about the straddle and strangle is that buying the call option and put option can be constructed in such a way that the combined price of the options is at its lowest point as a function of the underlying value at a given moment, while a direction either way will immediately lead to a value increase of the combination. In other words, the option that increases in value will do this at a faster pace than the value decrease of the other option. This of course sounds almost too good to be true, and there are indeed other elements that may influence the value of the combination in a negative way. The most important ones are the influence of time and volatility. However, in specific circumstances the choice for a straddle or strangle may be very attractive.

Firstly the combination needs a strong movement, without a preference for the direction of the movement, in order to be profitable. A highly volatile environment gives wider swings in either direction and therefore seems to be a natural fit for this option strategy.

Secondly the movement needs to take place rather quickly, when a combination is chosen with a short time until maturity. With these options the passing of time will have a strong negative impact, and because both a call option and a put option are purchased, the element of time works twice as hard to the disadvantage of the strategy. Keeping the position overnight is therefore quite risky, and in my experience option prices also tend to lose more value towards the end of the trading session. A position taken early in the day may have less of a negative impact from the loss of time value in the options.

Thirdly, a long straddle/strangle position is also long volatility. This means that increasing volatility leads to higher prices for both the call option and the put option. Decreasing volatility will lead to lower prices for both options.

1-day chart of SPX vs. VIX
click to enlarge

Here is where we see something interesting in current markets. On an intraday basis it can be observed that the VIX is moving in an opposite direction from the S&P 500 index with a very strong negative correlation. If the market goes up, the VIX goes down, if the market goes down the VIX goes up. The same can be observed in the relationship between the VXN and the Nasdaq-100 index. In this strategy we want the implied volatility in option prices to work in our favor, which means that the downward move of the underlying index is the preferred direction. Although I am very skeptical about the ability to predict short term price moves, I do believe an element of reversal to the mean can be observed, and that strong directional moves do run out of steam.

For the described strategy this means that if the investor is patient, there may be the occasional opportunity when this strategy has a higher chance of success than normally could be expected. The time to pay attention is when there has been a strong positive direction at the early stages of the trading day, or a flat start of the trading day after strong increases in the previous trading day. When this situation has occurred, a combination can be selected which is direction neutral, thus ensuring the lowest possible purchase price for the combination, and the highest chance of success.

It must be noted that bid/ask spreads and transaction costs will influence the outcome of this strategy. High underlying values and option series with high volumes and narrow spreads are therefore preferable.

Comments

[omooc]

For a novice, without any specific examples, one is unable to understand what you are talking about.
On the time of entering an order, again, it is difficult to see your recommendation (enter an order early in the day) without any specific examples.
You talked about "patience." Then you talked about entering a day trade. These 2 points seem to be contradictory.

[jcrash]

MEh, on the day of earnings sell a call and a put at the money.

The next day, buy them back. You will be up significantly. Volatility drops huge and prices are not moving that much. This has even worked on very volatile issues.

[Chungst]

To Jim C. who wrote: "MEh, on the day of earnings sell a call and a put at the money. ... This has even worked on very volatile issues."

If the stock gaps on earnings, you are screwed. Many option sellers faced this problem and were forced out. If you did that on VSDI for Q3:07 earnings (not to mention Q4:07 earnings), it went down huge as the stock got put to you.

[Chungst]

Note stock ticker should have been VDSI in prior post.

[Chungst]

To: Arco Wagemakers, I agree with omooc that you ought to have used an example to walk the readers through your recommendation.

Separately, the problem with strangles or straddles as you are aware is the frictional or transactions costs, i.e. bid-ask spread on two positions and commissions for two trades. Then you have to deal with short term capital gains.

Cheers.

[ArcoWagemakers]

To: Omooc, I don't believe there is a contradiction. You might make the analogy with the surfer who has to wait patiently for the next good wave to come along. But when it is there he needs to act decisively and try to ride it. When I trade this strategy again I'll try to document it.

[Dynamo2000]

I would like to add a point of clarification motivated by the strategy suggested by Jcrash and the comment Chungst made in response. I wish to emphasize that I consider my comments here to be that of clarification and not criticism since I do not know for certain what the exact strategy or intent are of the comments by the above two contributors. My understanding of Jcrash’s strategy is that selling a straddle on an earnings day can be very profitable. I have never tried or even investigated this strategy. (I certainly hope it is true). Chungst seems to be giving two perfectly valid examples of when this strategy did NOT work. As a part time investor always looking for new (better) and interesting strategies I would like to emphasize the following point. However valid Chungst (counter) examples may be, it has little bearing on the usefulness of the strategy Jcrash was suggesting. The critical issue in not whether Jcrash’s strategy works close to 100% of the time. The critical issue is whether the probablility of it working times the (expected) profit minus the probability of it not working times the (expected) loss is positive or negative. If it is positive you have a winning strategy. The more positive the better the strategy. My guess is that Jcrash is telling us that the “forever sought after number” is very positive! (I hope he is right). From a practical point of view to investigate the matter one must either look at historical records if available, and/or watch the market for a while and count your winnings and losses. What I have said is nothing new. Las Vegas for its part rakes in billions of dollars every year based on strategies that IN THE LONG RUN are positive for THEM (not you).

[Dynamo2000]

From an analytical point of view, for Jcrash's strategy to work it is necessary that there is a significant drop (volatility drops huge in his words) in the implied volatility between the day of earnings and the next day. Can anyone suggest a reason for this phenomenon or even relate their own experience in dealing with this?

[bill d]

Re: jcrashch method - As a semi-novice I can certainly see how you could get seriously killed. I don't see a way to minimize this - is there a way aside from keeping prices low ? I do sell puts on hi dividend stock I don't mind owning (and can afford to buy).