Straddle Follow Up

Last week I talked about using XIU straddles and short-term bonds as an alternative approach to medium and long-term fixed income securities. I was speaking about the use of straddles as a hedging mechanism that might provide the same level of protection normally associated with fixed income assets. And I posited that the duration risk associated with medium and longer term fixed income securities may create more portfolio risk than the short-term bond / straddle combination.

This week I want to focus on the straddle as an insurance policy which very different from making an investment decision in search of a positive return. With insurance you are buying protection and the objective should be to keep the costs as low as possible.

In the example cited last week the total cost for the XIU March (2014) 18 straddle was $1.60 per share. That is also the maximum risk although it is mostly theoretical. To lose the entire $1.60 XIU would have to close at exactly $18 per share at the expiration date in March 2014. The straddle would cost nothing and would generate a profit if XIU were to close above $19.60 or below $16.40 at expiration.

If we exercise some nimble trading throughout the next year we may be able to reduce the net risk associated with the straddle and by extension the net cost. For example suppose that XIU rallied to $19.50 per share. Your initial reaction would be to close out the straddle at a profit or at a minimum close the profitable side and continue to hold the puts.

Selling the calls while retaining the puts is not a bad strategy but it does enact a trade from the perspective of an investment strategy rather than an insurance product. While it may be the right investment strategy it reduces the impact of the insurance policy because the strike price of the remaining put is now $1.50 below our hypothetical price for XIU.

Another approach is to sell the put at a loss and replace it with a new put at the $19.50 strike price. Rolling up the put would probably cost 50 cents per share which means that you would now have $2.50 per share invested in the straddle. However you have reduced your maximum downside risk in the straddle to $1.00 per share rather than the initial $1.60 per share.

That’s because you now own XIU March (2014) 18.00 calls and XIU March (2014) 19.50 puts at a net cost of $2.50 per straddle. At the March expiration you are guaranteed to get back $1.50 per share no matter where XIU closes. More importantly you still own at-the-money crisis insurance.

The idea is to continue with these rolling strategies as the strategy works its way towards expiration. Each time you roll up or down the losing position you reduce the maximum risk associated with the trade while retaining the insurance.

If you want to see more on this you can request a PowerPoint presentation using Agrium, which details how you would roll up or down depending on where the stock went. Just post your request in the comment section.