Wednesday, April 7, 2010

The Straddle, Volatility Plays and the Greeks – Part 3

At long last, the short straddle discussion is here. Originally a theoretical short position in the SPY Apr 116 straddle could have been established in late March for a credit of $3.54, providing expiration breakeven prices of 112.46 and 119.54. Since the original trade date on March 23, SPY spent several days in the 116-118 range before pushing above 119 yesterday. So the position is dangerously close to being a loser come April expiration and more importantly is already a paper loser. Fortunately, implied volatility has declined and time has passed, both of which work in favor of the short straddle holder. So let's compare some of the changes in the approximate Greeks then and now.

SPY Apr 116 10 Contract Straddle
Mar. 23 (SPY @ 116.5)
Apr. 7 (SPY @ 119)
Apr. 7 (If SPY was @ 116)

The position is showing a paper loss of $120 and the short delta (∆) exposure has increased considerably as the calls have moved deeper into the money. The fact that the calls are roughly 2.6% in-the-money, has a limiting effect on gamma (Γ), theta (θ), and vega (v) which can be seen when compared to their respective theoretical values if SPY was closer to the strike. Generally speaking as stocks move further from the strike and expiration approaches, ∆ becomes more important than the other Greeks.

Managing ∆ risk also becomes increasingly important. Ideally of course, one does nothing and the stock returns to close right at the strike. However, most people tend to get a little nervous and choose to manage the ∆ risk to at least some extent. Unlike the long straddle position, where you buy low and sell high, the short straddle requires you to buy high and sell low if you want to remain ∆ neutral. You might ask why anyone would want to do that; because you are getting paid to assume that risk in the form of θ. Over the life of the position, the losses incurred from the buying high and selling low are hopefully more than offset by the declining value of the straddle. Like the long position, most traders use a mechanical approach on a percentage move, net ∆ basis, simply flattening out at the end of the day, or some combination of those parameters.

For example, if you are using a net ∆ approach, you might choose to purchase SPY when you reached negative 200 ∆'s. This likely would have occurred last week with the ETF around 117. The method would have you purchase 200 shares of SPY at that level. Since the stock continued to move higher, you would have been short (net of the first purchase) 200 ∆'s around 118 and then bought 200 shares more. If the underlying starts moving lower, you may need to sell some of this stock out to maintain a net position no greater than +/- 200 ∆'s. In this scenario, let's say that SPY is back to 116 and purchases of 200 shares were made at 117 and 118 as well as a subsequent sale of 200 at 117. For argument sake let's assume that SPY dropped briefly below 116 today causing you to sell 200 at 115.80, but is now back to 116 and the position looks like the last row in the above table. What has happened? Not including transaction costs, hedging with stock has lost $440, but the value of the position has decayed by more than $1000, yielding a net paper profit of $570.

As you can see holding a short straddle position can be a nerve racking experience because of the counter-intuitive way that you need to hedge. However, given the stock movement in this scenario, had you been long the straddle, you would be down $570 even though you are buying low and selling high! Clearly, straddles in general are for the more advanced trader and transaction costs become very important.

On a final note, the example used here involves an ETF which are much less likely to produce a significant gap. So there is an additional word of caution when employing a short straddle with an equity as an underlying. A good example of that would be today's action in Monsanto (MON). The stock disappointed the street with this morning's earnings report and gapped down to $67.53 on the open from a close yesterday of $69.80. During the first hour and a half of trading, it has traded as high as $71.26 and as low as $67.25, but is recently trading around $68.90. Anyone, who was short the Apr 70 straddle is likely to be having a very stressful day. As always, trading carries risks, understand them before you initiate a position and have a plan for hedging or closing that position in all scenarios.

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