Buying a straddle is a simple strategy that only involves buying the ‘at the money’ put and call. The combination of these two options create a spread and risk profile of extreme gains if the underlying product moves a lot. The risk to this trade is that the underlying product does not move or does not move enough to break even. This risk can be mitigated by looking at the relative price of options; implied volatility. Implied volatility can be used to determine the probability of moving a significant amount, along with the relative price of the contract. When one is looking to buy straddles, the optimal scenario is that implied volatility is low, however one has a strong thesis and conviction that the underlying is going to move a lot.
CBOE’s VIX, S&P 500 Volatility Index, is at three-year lows. This index is a measure of the aforementioned volatility. Over the last three years the VIX has had a range of $45, on the upside and $13, on the downside. Considering the VIX is currently trading at $16-ish, the low implied volatility criteria is checked, but what about conviction of a move?
The SPX dropped 16% during the debt-ceiling debacle. This precedence could be the foundation for the fiscal cliff trade. The chart below displays the SPX before and after the debt ceiling, and the chart below that displays the current SPX trend. With a few exceptions…the two charts mirror each other. Before the crash, the SPX rallied up to prior highs, or the highs established in the down channel. Perhaps if the SPX reaches there that would be the opportune time to put on duration straddles. Buying duration will increase the premium outlay, but if one could bet on anything it would be that government takes too long to figure things out under pressure.
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salernoma@mx.lakeforest.edu
