Doc Maher gets tied up with XLF.
You expect an explosive move in the Financial Sector, but you are not sure which way it will go. An appropriate vehicle would be XLF, an exchange traded fund for the financial sector. There are two main strategies that fit this description: a straddle or a strangle. Of course there are pluses and minuses to each one. Before we continue with Doc Maher's discussion, Nicole Wachs will lead us through the set-up.
THE PLAY - Long Strangle
TRADE FORMATION
On June 6th at 10:50 am
Strike A: Bought to Open 1 XLF July 24 Call (XLF GX) for 1.04
Strike B: Bought to Open 1 XLF July 23 Put (XLF SW) for 0.85
Stock at entry: XLF near 23.94
Strangle: 1.89 debit
Maximum gain: theoretically unlimited
Maximum loss: debit paid of 1.89
Break-even points at expiration: 21.11 (Strike A - total debit) and 25.89 (Strike B + total debit)
A strangle is commonly used when the stock is not close in price to a strike. At the time of entry, this ETF was pretty close to 24. Since this is nearly equal to a strike price (this ETF has dollar-wide strikes) one would usually use a straddle here. This helps the trader to be right in the middle of the action and not bias his or her opinion to either the upside or the downside. The strangle may also be used as a less expensive choice to the straddle. Although less costly sounds good, the stock will need to make a larger move in order to turn a profit in this trade. Practically speaking, the differences between a 24 straddle and a 23-24 strangle are not really significant because the strikes used are only $1 wide. The difference between these two strategies is more pronounced if the strikes are five dollars wide or more.
The goal here is for the stock to move sharply to one side and then exit the trade. For an in-depth look at this strategy, please login and head to TradeKing's Education Center. You will find it in The Options Playbook > Play #11.
FIELD CONDITIONS - the trading environment
The critical aspect of this trade is Implied Volatility. The best situation is for Implied Volatility to be low, with the outlook that it will increase over the course of the trade. The increase in volatility accomplishes two things. First, it increases the prices of both options you purchased. Second, it increases the likelihood that the stock will make a significant move.
ALL-STAR COMMENTARY - by Doc Maher
A strangle is a close cousin of the straddle, so I analyze the same things when considering this trade. You can read some of my earlier posts on straddles for more information:
Your Next Trade - Setting up a Straddle
The difference of course is that in the straddle we use the same strike price for both the call and the put whereas a strangle uses two different strikes. Often the strikes selected will create a delta neutral trade when the underlying is not near one strike.
Before we define this term, we need to define delta. Delta represents the change in price of an option for a one-point move in the price of the underlying security. Delta neutral means that the position makes the same amount if the underlying goes up or if the underlying goes down. This can be calculated by adding up the deltas of each option. The call has a positive delta and the put has a negative delta. The closer the total is to zero, the less directionally biased the trade is.
An example of a delta neutral trade is to buy a 23 Put and a 24 Call with XLF trading at $23.43. In the image below, you can see that the area on one side of the vertical line is nearly equal in size to the other.
Click here for a larger image.
Delta neutral technically means "zero delta" but anything between -10 and +10 would be close enough. The calculated delta for this sample position is +5.53, which falls in that range.
Take a look at the next image. This P&L graph resembles the trade set up when the position was initiated. As you can see XLF was trading about 50 cents higher, around 23.94. This by itself is not a problem, but it conflicts with the trader's outlook that XLF will be "most likely down" - this is because this strangle has a slight bias to the upside. How do I know? Because the stock and call strike are nearly equal. Also the delta of this trade is above the delta neutral range, giving this trade a slightly bullish opinion.
Click here for a larger image.
As you can see the Delta for this position is 18.94. This means that if XLF goes down one point, the position will lose $18.94. So this is slightly biased towards upward movement.
I would make two other quick notes on this strategy. The first concerns the trader's plan. He was expecting XLF to be down around $21 in one month. By using July options, one would experience nearly the entire negative effect of time decay if staying in the trade until expiration.
In the next image, the calendar has been advanced to July expiration allowing the break-even points to be visible.
Click here for a larger image.
If the trader is correct in his forecast, this strategy would only breakeven, since the lower break-even point is 21.11. If the move occurs sooner, this strangle could be profitable. If longer term options were used, the negative effects of time decay would be reduced.
The second point is related to the trader's comment that "XLF is seeing massive volatility (well, everything is according to VIX)." As mentioned above, XLF is an ETF representing the Financial Sector. The VIX measures the expected volatility of the S&P 500. For this trade, I would focus more on the next image - a Volatility chart for XLF.
Click here for a larger image.
This chart shows most recently the historical volatility (HV) has been moving down, however the implied volatility (IV) has been moving up. This relatively high IV indicates there is expected movement in XLF. However it also indicates that the options are priced relatively high. If the IV were to drop from its current level in the low 40s to last week's level of the low 30s, this would adversely impact a strangle. So this bears watching as well. Of course the IV could continue to go up and that would be very helpful.
While the Financial Sector certainly has the potential to move in this environment, both the time and IV are important things to watch during this trade.
"Income Trader"
For a list of previous All-Star Trades, please click here.
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This comment and any market data included here were completed on 6/9/08.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
