Jeff Pierce's  Instablog

The following is a post by Christopher Ebert, who uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. He studies options daily, trades options almost exclusively, and enjoys sharing his experiences with anyone who is interested.

Anticipating a downturn in Domino’s Pizza (DPZ), a short straddle at the $33 strike was featured back on December 21 as part of the Boring Trades Portfolio. Some questioned the rationalization behind selling a straddle instead of buying one; and with the underlying shares up 4% since the trade was opened, now seems like a good time to revisit this position.

• Short 10 DPZ Mar. 17 ’12 $33 Call @ $2.55 bid (currently $2.90 ask)

• Short 10 DPZ Mar. 17 ’12 $33 Put @ $2.05 bid (currently $1.45 ask)

The combined premium on an at-the-money straddle is almost entirely composed of time value. It seems obvious that time value is a function of time; but one of the more interesting aspects of options is that time value is often affected more by other factors than it is by time itself. Moneyness presents one of the more confusing influences on time value, and a straddle is one of the best illustrations.

When the underlying price changes, an at-the-money option will either increase in moneyness (it will go in-the-money) or decrease (out-of-the-money). In either case, the option will lose time value. Using the DPZ $33 straddle as an example; as the underlying shares climbed to $34, both the call and the put lost about $0.50 in time value each, while the call increased in intrinsic value by $1.00. For small changes in share price, the decrease in time value of both options is almost exactly equal to the increase in intrinsic value of the in-the-money option; a straddle is initially very close to delta neutral.

For larger price moves, delta on the in-the-money option increases while delta on the other option decreases. On the above trade, the $33 calls now have a delta of 0.6, while the puts are at -0.4, so net delta on the straddle is 0.20; in other words, for every dollar increase in share price, the straddle is currently gaining 20 cents in value. Because this is a short straddle, increasing value is unwelcome because it raises the potential cost to close the trade by buying back the options. One consolation is that net theta is currently about -3 cents per day, so an increase in the value of the straddle of 20 cents would be completely offset by time decay over the next 7 days. At this point in the trade, what the analysis of net delta and net theta reveals is that Domino’s shares would need to increase by more that $1 within a week in order to make the trade unprofitable.

Just in case the stock continues to rise, there is an open buy limit order to purchase 100 shares at $37.00 (to cover the short call) with a stop loss at $33.00. Normally, a conditional order would be entered, to buy the short put if the share purchase gets tripped; however, that is not an alternative with these particular options due to a lack of liquidity. In any case, buying the shares would be a last ditch effort to eliminate losses. Although it’s not a perfect solution, the chances would be good that the shares would get called away at the $33 strike price, and the combined premiums received on the short straddle would offset the capital loss.

For now, the trade is within its safety zone. Due to the nature of a short straddle, this is one of the few positions where whipsaw is actually a friend. A piece of advice to any trader who considers whipsaw an enemy: Find option positions that make anything but the most violent whipsaw a welcome guest.

Questions or comments about this, or any other option trade are encouraged. Feel free to enter them in the comment section below.

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