An interesting Trade

Posted on March 15th, 2013

With the market pressing to new highs and the VIX pushing to new 6 year lows, we’ve observed an interesting trade occurring in the options market.  Starting back on March 6th, there has been a regular accumulation of an SPX straddle at the 1500 strike out to January.

A straddle is when a call and a put are purchased at the same strike price and it pays off when the underlying, in this case the S&P 500 moves enough in either direction to offset the combined cost of the those option legs. Below is an example of what a risk chart looks like for that trade based on today’s prices.
Looking in the option chain, one can see that there are about 15,000 open contracts in the JAN SPX 1500 calls and puts alike. Of which 10,000 have been accumulated over the last 8 days.  We point this out, not because we agree with the trade, but because it someone taking advantage of the low cost of volatility.

While we don’t know the exact cost of the position, if it was to be put on today, the break-even levels of this straddle are SPX below 1321 or above 1678. If indeed this position was put on with an average cost of $178 per contract this trade would cost a huge amount. 178 X 100 X 1500 comes to $268 million dollars. That is a huge bet.  Not knowing if there are other pieces to this overall position makes it difficult to project what the overall thesis of the position is.

For example, at the September expiration there are 25,000 contracts at each of the 1500 call and puts. If those were sold at $133 that number comes to a credit of $332 million (25,000 X 100 X 133). This might be their way of generating sufficient income to pay for the speculative play, and significantly changes the profile of the trade. These are huge numbers, period, end of story.

This brings us to our next point. Generating income via selling options is an effective way to help pay for the long options. If you’ve read our blog before, you know we generate income with a strategy known as our high probability credit spread (HPCS). The strategy aims to pull small amounts of cash by selling deep out-of-the-money options and waiting for them to expire worthless.

If we were looking to capitalize on the low cost of volatility right now with a speculative trade, we probably would use the HPCS to generate sufficient income to pay for our straddle. The question is how much is needed.

Looking at the market today a single contract for an at-the-money straddle out to January 2014 at the 1550 level would cost you about $168 or $16,800 (168 x 100 x 1). This straddle would represent a notional value of $155,000 of portfolio value at a cost of about 11%. The max loss of this position is the $16,800 put out to establish the long positions and occurs if the market closes exactly at 1550 on JAN 2014’s expiration in 10 months.

For every $155,000 worth of portfolio value there is going to be $138,200 of free cash (155,000 – 16,800). We can use that free cash to sell our HPCS and pay for the $16,800 cost of our long straddle. If you wanted to completely sell enough to offset the straddle cost, you would need to return 12% on the HPCS (16,8000 / 138,200). Based on our historical performance, this is very achievable.

As a reminder, there is no reward without risk, so understand that the mathematical risk associated with the HPCS is actually much greater than the risk of the long straddle. If the market moves downward quickly the straddle will make some fast money, but the HPCS becomes at risk and the whole $138k can go up in smoke if you don’t define your exits. We’re written plenty about that before so be sure to be comfortable with it before using that tactic.


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2 Comments

Bruno - March 22nd, 2013 at 4:48 AM
Could you elaborate on this HPCS strategy you mentioned at the end of this article? Thanks.

- March 22nd, 2013 at 12:20 PM
Bruno,
The HPCS (High Probability Credit Spread) is a strategy we write about on a monthly basis that sells deep out-of-the-money spreads for small chunks of income. It benefits from the natural decay of option prices and uses probabilities to determine strike levels. Below is a link to our post in February about a trade we made for March.

http://buyandhedge.com/blog/2013/02/14/march-high-probability-credit-spread-trade

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