1. INTRODUCTION
Market volatility is at an all time high. With the ups and downs many investors cannot find the confidence to come back to the market and stay invested. This article discusses a simple strategy that has proven tremendously profitable in recent weeks, and than can be used by both small and large investors. The strategy allows profits regardless of market direction. While the market has in general pointed down lately, it has also suffered several corrections, and is currently due for a significant correction to the upside. The strategy discussed here returned profits of hundreds of percentage points, or several times the invested capital.
The strategy consist of using straddles on IWM, an ETF that tracks the Russell 2000 index. This index tracks the performance of 2,000 small-cap companies in the US broad equity market.
A straddle is a known technique in which the investor buys both a call and a put of the same underling stock. The straddle holder is then both long and short at the same time. The straddle becomes profitable when the stock moves enough either way, up or down. When the stock moves up, the value of the call option rises. Often, the rise is enough to cover the price paid for both the original call and the put. Similarly, when the stock goes down enough, the value of the put increases, and with a large enough move it will be worth more than the value of the call and the put combined.
For example, consider an IWM straddle bought on October 14 when IWM was trading around $56:
Total purchase cost: $4.00. Two days later, on October 14, these positions were worth $7.40, for +85%:
A strangle is a similar strategy except that the call and put strike prices are spaced out at a delta from the underlying stock price. For example, buying a call 65 and a put 55 in the above case.
The idea is also that the strangle will be profitable if the stock moves enough beyond either strike price. A strangle is cheaper to buy and thus can be more profitable, but it is riskier. If the stock ends up with a final price between the two strike prices both options will end up worthless. Using the same IWM 60 as an example:
Total purchase cost: $2.10. Four days later these positions were worth $5.40, for +157%
The charts below shows what happened with both IWM and the premiums of both a $60 call and a $60 put during the last 2 weeks of October expiration.
(Please click on image to enlarge)
The effects of the IWM swings can clearly be seen on the values of the call and put premiums.
WHY USE IWM?
IWM is a great vehicle because if is very liquid, and its options have a very small bid-ask spread (the difference in price you lose when you buy and the sell an option, just like a when you buy and sell a stock). Often the bid-ask spread is one or two pennies. IWM also allows small investors to use this strategy with as little as a couple hundred dollars on each side of the straddle. In addition, because it contains 2,000 stocks, IWM cannot be easily manipulated as for example the DIA (Dow 30).
This strategy was applied to the market in the last 4 weeks. It achieved tremendous returns. On average, peak profits during the last 2 weeks were in the hundreds % points. An investor who had sold each straddle upon hitting specific profit levels and then reinvested by buying another straddle could have achieved around 300% profit.
2. PERFORMANCE ANALYSIS AND RESULTS
The chart below shows the performance of IWM during the last 2 weeks, which coincide with the October options month, ended on Friday October 17 2008.
The numbers in red on the charts represent the crossings over integer price values. This article analyses the performance of each point assuming a straddle (or a strangle) was bought in each and every one of these points. Any crossing value could have been chosen, not necessarily over integer values and the results would have been similar.
(Please click on image to enlarge)
STRADDLES RESULTS:
A straddle was bought whenever IWM crossed an integer value. For example when IWM crossed 54, a call and a put with 54 strike price were bought. As a result 95% of the positions were profitable. The average maximum profit was +66.6%. The maximum profit was +149.0%. These results are shown in the table below:
Overall Average Performance: +66.6%
Maximum Performance: +149%
Week 1 Performance (Oct 6 To Oct 10): +81%
Week 2 Performance (Oct 13 To Oct 17): +59%
Percentage of points profitable: 96%
Only one position had negative returns. This position was bought on the day prior to expiration, which is risky timing: only 1 day to expiration of the options.
STRANGLES RESULTS
We now analyse the performance of strangles.
· STRANGLES $1:
Strangles with a delta of 1, meaning they are off from the underlying stock price by $1. If the stock was $52, a call 53 and a put 51 were bought. These options are cheaper than with pure straddles and they require larger moves of the underlying stock to achieve a profit. However, if these moves happen, the gains are higher, potentially much higher.
Results:
Overall Average Performance: +89.9%
Maximum Performance: +201.2%
Week 1 Performance (Oct 6 To Oct 10) +109.5%
Week 2 Performance (Oct 13 To Oct 17): +75.8%
Percentage of points profitable: 95%
· STRANGLES $2
Overall Average Performance: +131.3%
Maximum Performance: +405.0%
Week 1 Performance (Oct 6 To Oct 10) +114.0%
Week 2 Performance (Oct 13 To Oct 17):) +141.2%
Percentage of points profitable: 95%
· STRANGLES $4
Overall Average Performance: +147.3%
Maximum Performance: +370.0%
Week 1 Performance (Oct 6 To Oct 10) +214.1%
Week 2 Performance (Oct 13 To Oct 17): +116.7%
Percentage of points profitable: 95%
· STRANGLES $6
Overall Average Performance: +198.9%
Maximum Performance: +600.0%
Week 1 Performance (Oct 6 To Oct 10): +194.8%
Week 2 Performance (Oct 13 To Oct 17): +201.4%
Percentage of points profitable: 93%
· STRANGLES $10
Overall Average Performance: +238.0%
Maximum Performance: +%
Week 1 Performance (Oct 6 To Oct 10): +330.0%
Week 2 Performance (Oct 13 To Oct 17):) +176.8%
Percentage of points profitable: 92%
The chart below shows the individual results of the some of the points for straddles:
(Please click on image to enlarge)
The chart below shows the individual results of the some of the points for strangles:
(Please click on image to enlarge)
3. EXIT STRATEGY
There are many possible edit strategies. At some point the straddle must be sold or price decay will eat into the profits (options prices, or premiums, decrease with time).
Buy and Hold: The investor buys the straddle and holds until near expiration. This may be useful when you buy early in the options cycle (week 1 or 2), and also when the market is moving sharply one way or another. In the end the investor hopes that one of the straddle branches will be worth far more than the other.
Partial Sell: the investor sells one side of the straddle when the costs have been recovered, leaving the other side to potentially capture gains if the market reverses subsequently to the sale. This can be a very rewarding strategy in times of volatility and continuous ups and downs. For example, if the market drops, your puts will cover the price of both calls and puts, so you sell the puts. You may at the same time also sell the calls at whatever remainder value they have, or you may choose to keep them. If the market rebounds you will now profit again from the calls.
Full Sell: Sell both calls and puts when a target profit has been reached. This may be 10%, 25%, 100% profit, whichever you choose.
Full Sell and Reinvest. You may sell when you have a profit and reinvest the profits as another straddle! You can keep doing this forever.
Buy More of the Weak Side: This also works when the markets keep oscillating. Whenever it drops, you buy more calls as they are now cheaper. Whenever it rises, you buy more puts, and so on.
There are many other strategies, each suitable for different investment styles and goals. Also, investors should ensure that mental stops are in place. If the markets do not move, the options bought will drop in price due to time decay. At some point the investor must sell to avoid losses.
Take profits frequently! This market has a tendency to do the unexpected. You never know when another bank will fail or when a trillion dollar bailout will be announced.
Because the markets are so currently volatile, it is extremely important that you have an exit strategy and that you sell your straddle at some point. We saw above that in October almost all positions became profitable. However, if you had not sold them, you could still incur losses.
RESULTS FOR CUMULATIVE REINVESTMENT USING SELLING THRESHOLDS
Straddles can be sold whenever a certain profit target was reached, and then another straddle was immediately bought. For example, if a target of 25% is set, a straddle bought on Tuesday October 7 would have been sold and bought again at least 5 times, providing a return of over 200% for the investment.
Threshold CumulativeReturn
10% 61%
15% 101%
20% 148%
25% 205%
30% 261%
LONG TERM STRADDLES
Below you see the performance of straddles bought a full one month and fifteen trading days ago.
These straddles generated very high profits, in the order of 300%, 50% or 600%. Strangles generated even higher profits, up to 950%. The reason for this is that IWM in general came down crashing during the last 30 month, having dropped about 30%, so the longer you held the original puts, the more valuable they became. However, a drop of 30% in one month is quite unusual. However, with straddles investors would profit if the market went up or down.
Straddles held for 30 days:
Straddles held for 15 days:
The chart below shows the performance over time of the 72-72 straddle.
And the chart below shows the performance of a straddle and a strangle on top of the price of IWM.
(Please click on image to enlarge)
4. VOLATILITY CONSIDERATIONS
The chart above shows the CBOE volatility index, which has been steadily increasing and is currently at record levels. The VIX index went from 32 to 71 in the last 4 weeks. When volatility increases the price of options rises as volatility is one of the components in which options premiums are calculated. The inverse is also true. If the market rises again, VIX will also likely drop, and so will partially the prices of options. Consequently, profits on the upside may be more difficult than on any downside. It is hard to conceive the VIX higher than what it is today, but very few people would have expected to see it ever pass 50!
5. CONCLUSION AND FUTURE INVESTMENTS
Straddles are potentially a very profitable way to invest when markets are volatile because they allow profits when markets move either way, up or down. By using straddles investors can achieve very high returns in these uncertain times.
IWM straddles in particularly useful because the options are very liquid and the bid ask spreads are very narrow. They also allow investors to spend only a few hundred dollars at a time. A straddle with strike prices that are off by 5% to 10% from the current stock price can usually be bought for a couple hundred dollars (plus commission) for the calls and a similar amount for the puts. Also, usually IWM options ‘at market’ orders perform very well as liquidity is excellent.
For the upcoming November expiration month, premiums are still quite expensive. To lower the cost, out of the money strangles could be considered.
Investors should always keep in mind that options are risky as they suffer from time decay that works against the buyer. Eventually all options that are out of the money expire worthless. In fact, this is what happens with the vast majority of options. Past performance is also not a guarantee of future performance.
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