Timing A Straddle

Last week I talked about the outlook for the markets in 2013. Specifically that we will likely see long periods trading within an ever narrowing channel punctuated by short bursts of volatility where markets move sharply before settling in a new trading range.

Mind you that is typical market maneuvering in most years although I think 2013 will be more pronounced with government actions or inaction being the catalyst for sentiment shifts that cause volatility spikes.

This week I want to look at straddles as a strategy that takes advantage of volatility extremes. A straddle involves the simultaneous purchase of a call and a put on the same underlying security with the same strike price and expiration date. As of Friday’s close the iShares S&P / TSX 60 Index Fund (XIU) were trading at $18.35. The XIU March 18.50 calls were trading at 60 cents while the XIU March 18.50 puts were trading at 40 cents. Total cost for the XIU March 18.50 straddle is $1.00.

The straddle makes money if the underlying security moves beyond the trading range as determined by the net premium paid for the call and the put. The XIU 18.50 straddle will be profitable if by expiration XIU were above $19.50 or below $17.50.

Because a long straddle incorporates two short-term options that are negatively impacted by time decay you should have an opinion about whether the straddle is overstating or understating future volatility. You trade straddles at extremes. You buy a straddle if you believe volatility has contracted to an extreme level or sell straddles if you believe volatility is at an extreme high. Look entry and exit points based on extreme readings benchmarked against historical norms.

To ascertain extreme readings look to the S&P/TSX 60 VIX Index (symbol VIXC) which measures the volatility being implied by near-to-the-money options S&P TSX 60 Index. The VIXC closed at $12.41 on Friday. That’s a 52-week low but is it an extreme reading?

To ascertain extremes necessitates boundaries which require a normal value as the mid-point. What is a normal volatility level? Obviously there are many interpretations about what constitutes normal! For me I use the VIXC 50-day moving average to represent normal volatility because it reflects different market environments and removes much of the day to day noise.

If the daily VIXC is above the 50-day “norm” the implication is that options are relatively expensive. When it trades below the “norm” options are cheap. But knowing that options are cheap or expensive does not tell us if volatility has reached an edge that typically precedes a major change in direction. To determine extremes we have to integrate another technical tool; Bollinger Bands.

The Bollinger Bands, developed by John Bollinger, graphically display a two standard deviation trading range around a moving average. In this example the 50 day moving average is being used to normalize volatility and the 50 day Bollinger Bands graphically display an expected trading range around the VIXC moving average.

You can chart Bollinger Bands on the VIXC by going to www.tmx.com. Enter VIXC in the quote bar which will show you the current value. You will see a chart to the left. Move the cursor over the chart and double click. You can then build on the chart by moving down the page where you will find Bollinger Bands in a pull down menu to the right of “Upper Indicator.” At that point you will see a box to the right of the Bollinger Bands that reads 20,2,0. Change the 20 to 50 and voila you have 50 day Bollinger Bands around a 50 day moving average.

Extreme readings would occur if VIXC were to touch the upper or lower Bollinger Band. As of last Friday the VIXC was bouncing off the lower 50 day Bollinger Band which suggests that the VIXC is at an extreme level that supports a breakout in volatility that would illicit higher values for XIU calls and puts.