An apartisan high-low-energy election strategy straddle

October 21, 2016 01:00 PM
How do you play a market that’s likely to break out in either direction based on election results? A long straddle.

How will the November Presidential election affect energy in general, and the coal industry specifically? The contrast between the two major candidates is glaring. This brings up a possibility for an options strategy you can enter now.

Democratic Nominee Hillary Clinton has promised to continue the Obama Administration policies regarding fighting global warming, which along with cheap natural gas has been extremely harmful to the coal industry. Republican Nominee Donald Trump, on the other hand, has pledged to increase energy in all shapes and sizes, remove regulation, reduce taxes and encourage further energy production.

Given the differences in policy, investors can position themselves to take advantage of the election’s outcome. But with the polls narrowing in early September, which way should you go? One solution is the long strangle. This is a two-part strategy involving the purchase of a long call and a long put, both out of the money. For options with a long time to expiration, this strategy can be expensive. But one coal-focused ETF offers a strange close-to-the-money strategy for a very affordable price.

A long option is one in which the benefit occurs as long as the price moves far enough away from the strike. So, it has two breakeven points, one above the call’s strike and the other below the put’s strike. 

An example of a long straddle you can enter today is based on closing price on Sept. 2, 2016. You will want to adjust these prices based on the current underlying share price, but the key element to consider is the dollar risk versus the potential for stock price movement.

The Van Eck Vectors Coal ETF (KOL) closed on Sept. 2 at $10.78. “Decision point,”(below) shows KOL in a consolidation after rebounding from a multi-year downtrend. KOL’s value has doubled in 2016 after losing more than 90% of its value from 2011 through 2015. 

A long straddle could be set up with the following positions based on the options expiring on Jan. 20, 2017 (139 days from the close):

BUY one 11 call @ 0.90, plus $9 trading fee = $99
BUY one 10 put @ 0.85, plus $9 trading fee = $94
    TOTAL debit = $193

The two breakeven prices are based on the premium and strike:

Upside breakeven: call strike 11 + premium 1.93 = $12.93 per share
Downside breakeven: put strike 10 - premium 1.93 = $8.07 per share

As long as the share price moves above $12.93 or below $8.07 before expiration, the overall position will be profitable. 

This example was based on a very long-term set of options. As the election draws closer, the same options will be much cheaper due to time decay, so the breakeven is likely to be much closer to the strikes. The options will be cheaper, for example, if you select the November or December expirations immediately before the election. This assumes that the outcome will affect share prices immediately. Given the extreme differences in stated policy and the ramifications of both candidates’ policies, a post-election reaction is likely.

Options strategies such as this are a matter of timing. If there is a post-election effect in the price of KOL shares, it will be too late to exploit. You need to enter a trade like this before the election so that you will benefit from movement in either direction. The best positions are low-cost but positioned to benefit with movement in either direction.

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