Interesting SPY Straddle Purchase Strategy:
In case you are new to options or have been living under a rock for the past few months, you know that option prices are at historic lows. The average volatility of SPY options (VIX) has been just over 20 over the years. This means that option prices are expecting the stock (S&P 500) will fluctuate about 20% over the course of a year.
Right now, VIX is hanging out at less than 13. Option buyers are not expecting SPY to fluctuate very much with a reading this low. Since in reality, SPY jumps around quite a bit every time the word “tapering” appears in print, or the government appears to be unwilling to extend the debt limit, there is a big temptation to buy options rather than selling them.
Today I would like to share with you an idea we have developed at Terry’s Tips that has been quite successful in the short time that we have been watching it.
Interesting SPY Straddle Purchase Strategy:
For many years, Terry’s Tips has advocated buying calendar spreads. These involve selling short-term options and benefitting from the fact that these options deteriorate in value faster than the longer-term options that we own as collateral. However, when option prices are as low as they are right now, this strategy has difficulty making gains if the stock fluctuates more than just a little in either direction. Volatility has always been the Darth Vader of calendar spreads, and with option prices as low as they are right now, it only takes a little volatility to turn a promising spread into a losing one.
If you could get a handle on when the market might be a little more volatile than it is at other times, buying options might be a better idea than selling them. At Terry’s Tips, we admit that we have no idea which way the market is headed in the short run (we have tried to guess a number of times, or used technical indicators to give us clues, but our batting average has been pretty close to 50% – we could have done just about as well by flipping a coin).
With that in mind, when we buy options, we usually buy both a put and a call. If those options have the same strike price and expiration day, the simultaneous purchase of a put and call is called a straddle.
If you had a good feeling that the market would soon make a big move and you also had no strong feeling which direction that move might take, you might consider buying a straddle.
We did a backtest of SPY price changes and discovered that in the final week of an expiration month for the normal monthly options, SPY tended to fluctuate more than it did in the other three or four weeks of the expiration month.
Three months ago, we decided to buy an at-the-money SPY straddle on the Friday before the week when the monthly options would expire. We hoped to buy this straddle for just over $2. If SPY moved more than $2 in either direction at some point in the next week we would be guaranteed to be able to sell either the put or call for a profit (our backtest showed that SPY moved by more than $2 on many occasions on a single day).
On Friday, September 13th, we discovered that at-the-money the straddle was trading about $2.50, more than we wanted to pay. There was a reason for it. SPY pays a dividend four times a year, and the ex-dividend date is the Thursday before the monthly options expire. When a dividend is paid, the stock usually falls by the amount of the dividend (about $.80) for SPY on the day after it goes ex-dividend (all other things being equal). For this reason, in the days before that happens, the put prices move much higher in anticipation of the stock falling on Friday. This pushed the straddle price higher than we wanted to pay.
We decided not to buy the September at-the-money straddle on Friday the 13th (maybe it would be bad luck anyway). But we should have coughed up the extra amount. The stock rose more than $3 during the next week, and we could have collected a nice gain.
When the October expiration came around, we could have bought an at-the-money straddle on Friday, October 11 for just over $2, but the portfolio that we set up to buy straddles had all its money tied up in straddles on individual companies. So we didn’t make the purchase. Too bad, for in the next week, SPY rose by over $4. We could have almost doubled our money.
Finally, on November 9, we finally got our act together. It was the Friday before the regular monthly options were to expire on November 15. When the stock was trading very near $176.50, we bought the 176.5 straddle which was due to expire in one week. We paid $2.16 for it.
We had to wait until Thursday before it moved very much, but on that day when we could claim a 20% gain after commissions, we sold it (for $2.64). The stock moved even higher on Friday (up $3.50 over our strike price), so we could have made more by waiting a day, but taking a sure 20% seemed like the best move to make. We plan to make a similar purchase on Friday, December 13th, at least those of us who are not spooked by superstitions.
For three consecutive months, buying an at-the-money SPY straddle on the Friday before the monthly options expire has proved to be a profitable purchase. Of course, we have no certainty that this pattern will continue into the future. But these months did confirm what we had noticed in our backtest.