From the October 01, 2012 issue of Futures Magazine • Subscribe!

Using straddles and strangles to trade a “too close to call” election

Options Strategy

Question: How can you trade a “too close to call” election?

Answer: Execute a volatility play with the use of straddles and strangles.

Options premium consists of two components: Intrinsic value and time value. Intrinsic value is the in-the-money portion of the premium. For instance, with the gold exchange-traded fund (ETF), GLD, October 158 calls trading at $4.50 with GLD trading at $159.10, there is $1.10 that is in-the-money. This portion of the premium is not affected by the passage of time or traders’ expectations. The $3.40 portion of the premium is affected by both of those factors and is called time value. Intrinsic value also is known as expiration value because only the in-the-money portion counts, or survives, at expiration. 

Events that affect time value include earnings reports, crop reports and Food and Drug Administration announcements. Until the results of those events are released, time value generally remains at an abnormally high level. Once the results are known, there is a big drop in the time value that is embedded in the options premium. These events in the future represent unknowns that can have a large effect on value; the less time and fewer events that weigh on price, the lower the theta, or time value. 

One also needs to know the difference between historical volatility and implied volatility. Historical volatility relates to the movement in the underlying instrument (stock, ETF, futures contract, index) to date. Implied volatility is the indication of the future movement in the underlying instrument based upon the price level of the options currently traded. For instance, if the Hewlett-Packard (HPQ) September 19 straddle was trading for $2.00 with four weeks until expiration and HPQ was trading at $19, the options would imply that HPQ would trade in the $17-$21 range over the next four weeks. You then back in these numbers and come up with the number for implied volatility.

The upcoming presidential election has some similarities and dissimilarities to the aforementioned events. A great deal of uncertainty will be eliminated after the election results. The major difference is that there are no daily tracking polls that indicate the result in the earnings for IBM.

So what are the chances of President Barack Obama being re-elected? The website gives him a 55.7% chance of winning re-election as of this writing. On the other hand, most polls have the election as a dead heat or favor one side by a slim percentage within the margin of error. It appears as though it will be a very close election. 

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