To pickup on yesterday’s discussion regarding long volatility plays, suppose I slapped on a February ATM straddle on the SPDR S&P 500 ETF (NYSE:SPY) as a means of loading up on the ostensibly cheap volatility. Currently the Feb 127 call is trading at $2.57 and the 127 put is trading at $2.60 for a total straddle price of $5.17. The implied volatility of both options, by the way, is sitting at 16%.
Now, there’s a few different ways we can analyze the volatility we’re paying for. We could keep it simple by looking at the expiration break-even prices to get a sense of how far the stock has to move to allow us to at least recoup the cost of the trade. The upper break-even comes out to $132.17 and the lower break-even comes out to $121.83. That’s roughly a 4% move in about six weeks.
As most traders avoid holding straddles all the way to expiration, using the expiration break-even prices may not be the most effective method of analysis. Fortunately, there are alternatives. We could look instead at the average daily moved being priced into the straddle. Consider the following table:
Given the SPY’s current price of $127 and an implied volatility of 16%, the straddle is pricing in about a $1.28 (1%) move per day. That’s the expected volatility. Your opinion on whether or not that’s too high or low will dictate whether you think straddles are a good buy here. If you believe daily moves of over 1% are about to become the new normal, then from a volatility perspective the straddle purchase makes sense. Do keep in mind however that despite the mild uptick in intraday volatility we’ve seen since the beginning of the new year, the average daily move (from close to close) over the last five trading days has been an anemic $.28. Not exactly the type of price action straddle owners dream about, ya know?
Bottom line: Current straddle buyers better be comfortable betting on a change in character coming around the corner (the quicker the better). If last week’s price action is setting the tone for the month to come, straddles face a serious uphill battle. But, who knows? There may be a two or three standard deviation move lurking out there somewhere. The million dollar question is whether it will arrive in time for those hopeful straddle owners.
ABOUT: Tyler Craig, author of Tyler’s Trading and owner of TC Trading, Inc. Over the years I’ve educated hundreds of traders through my work with one of the nation’s leading educational firms. I enjoy writing and am a current monthly contributor to the Wealth Intelligence Magazine. My writings have also been featured in Expiring Monthly and frequently show up in the Abnormal Returns Options Newsletter. In 2009 I started Tyler’s Trading to share daily market commentary on stocks and options.