Straddles for an uncertain environment

As I see it there are three major and seemingly conflicting factors at play in the financial markets.

The domestic macro issues are of course, front and center. In the US, there is uncertainty as to who will win the presidential election and what will that means for consumers, investors, the fiscal cliff and the inner workings of the US Federal Reserve (Fed).

Mr. Obama would likely keep Mr. Bernanke on the job and keep the printing presses running at full speed. Mr. Romney wants to replace Fed Chairman Bernanke and would likely have the Fed be less dovish.

Both men want to illicit changes in the tax code. Mr. Obama would let the Bush tax cuts expire for the rich, and may up the rate on dividends and capital gains. Mr. Romney wants to reign in deductions, lower the personal tax rate and perhaps cut or eliminate tax on dividends and capital gains. Neither candidate seems to have a real plan for the so-called fiscal cliff.

The second factor is the eurozone which remains a loose affiliation of states with conflicting agendas. Think about the eurozone problems as if they were the US on steroids. Nothing good is likely to come out of this part of the world for some time.

The third factor is investor complacency which seems oddly out of place given the current state of affairs. I note that the MX’s S&P/TSX 60 VIX Index (VIXC), which measures the level of volatility being implied by premiums on S&P/TSX 60 index, continues to track along the bottom of its trading range. Volatility of course, is how the options market quantifies risk.

One would think, given the uncertainties and potential repercussions from any of the other factors, that volatility would be higher. As much as 30% higher in fact!

The point being low volatility opens the door for long option strategies that would profit should events take a wrong turn. Particularly if pending uncertainty leads to a crisis of confidence!

To that end, you might look at long straddles which involves the purchase of both calls and puts on the same underlying security.

The straddle is a non-directional trade in that profits from a significant move up or down in the underlying security. It is not about the direction of the underlying security, only that it moves by a greater amount than the total cost of two options.

The straddle can also profit should the underlying security move up and down more dramatically than it has in the recent past. In that scenario volatility would increase which would push up the value for both the call and the put.

With the VIXC at the bottom end of its trading range it means that options on the iShares S&P/TSX 60 Index Fund (TMX: XIU) are relatively inexpensive. All of which enhances the profit potential and portfolio benefits inherent in straddles.

To make the point consider five month at-the-money straddles on XIU which closed on Friday at $17.71. The XIU March 17.50 calls were trading at 82 cents while the XIU March 17.50 puts were trading at 63 cents. The total cost for the XIU March 17.50 straddle is $1.45 (i.e. 0.82 + 0.63 = $1.45).

The XIU straddle is framing an implied trading range for XIU between now and the third Friday in March 2013. Ostensibly if we were to add the $1.45 cost of the straddle to the $17.50 strike price we have an upside target of $18.95. Similarly if we subtract the $1.45 straddle cost from the $17.50 strike we have a downside target of $16.05.

To that end, the straddle makes the most sense if you believe that XIU will likely breech either end of that implied trading range over the next five months. That said, the straddle can also profit if XIU moves significantly within that range over the next five months.

That you can buy a straddle when traders are most complacent also adds a measure of insurance to your portfolio. The straddle will be profitable should the market fall sharply which would offset some of the losses with the more traditional assets in your portfolio.