Monday, February 23, 2009

Protect Yourself: Straddles for March

The market today broke the S&P 500 was trading around 750. Technical analysts say that, if confirmed, this a major support that has been broken (755), and a major downtrend is possible.

Whether this analysis is correct or not, investors can protect themselves by using straddles. With straddles it does not matter if the government annoucnes a mahor deal that will save the banks and the market rallies, or if they banks will be nationalized and the market plunges. It also does not matter if the market is rigged and is manipulated to the upside or to the downside.

IWM is a favorite vehicle for straddles because of its liquidity and narrow bid-ask spreads. Here are some straddles for March, taken when IWM was trading between $39.96 and $40.10.




Note how the number of calls starts to be quite different from the number of puts to maintain the same $1,000 investment in each branch of the strangle.


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Michael said...

Hi again,

I'm looking at IWM using yesterday's close of day prices and the calculator. IWM closed at 39.56 and the 40 calls and puts closed at 1.96 and 2.28 respectively giving a premium of 1.96 + .44 = 2.40 and 2.28 - .44 = 1.84.
Plugging those numbers into the calculator, I am given 4 calls and 5 puts, Max move req. to upside: 0.45% and to downside -18.56.

Now the dumb question. What do I do with this? Rejig the strikes until the Max moves are more in balance?

Much appreciated.

The Shocked Investor said...


I pluggged those number in as well:

The max move required is 10.84%, likely much less since there are 245 days left.

The $0.44 you are referring to is embedded in the calculations.

BTW, if you use $2k on eadh side the number is 10 calls-9puts.

Hope this helps.

The Shocked Investor said...

Make that 25 days.

Michael said...

I know why you are the Shocked Investor... shocking how dumb this reader is. For that, I am grateful for your attempts at enlightenment and, thankfully, the light is slowly coming on.

Since my crappy trading platform (Etrade Canada) does not allow trading in options in less than increments of 5, I plugged $2000 for calls$ and $2200 for puts$, giving me an investment of 10 and 10 and 11.83% and -9.61%.

What are the risks of this? I guess it would be that neither move happens, unlikely, or I stupidly don't cover while the prices are beyond the lower and upper bounds?

Thanks again.

The Shocked Investor said...

Well, I need to put in some instruction on that tool, lack of time!

The risk is that IWM does not move, or that it moves partially up, say 5-6%, followed by 10% down and you are stuck in the middle. One thing you can do is sell part of the calls if it goes up 5% and you see the market overbought.

As the tool says, if you get the 10 or 11% move you are guaranteed to make profit, but that is the move required. If the move does not happen, you may (or not) incur a loss.

What do you mean ETrade only allows options in multiple of 5? You cannot buy 1 or 2 contracts if you wnated to?

Michael said...

Wrong about Etrade. It is the price increment, not volume increment.

Anyway, I have charged ahead with a straddle of TBT:
price: 44.35
Mar 44 calls: 4 @ $2.45
Mar 44 puts: 5 @ $2.05
Move up req'd: 10.51%, down: 9.83%

Total cost $2,005. My money to lose. Thanks for your help.

The Shocked Investor said...

Interesting trade. Stocks up today and TLT is up too. Bubbles are good candidates. Best of luck!
A related trade is TLT, 105-106 strangle requires 6.80%.

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