Question: What do you do when the market has you spooked and the only thing you are sure of is more volatility?
Answer: A short time spread
Equity market volatility has elevated after the most recent concerns about a possible double-dip recession. Even an eternal optimist would be hard pressed to find good news for the stock market. Yet, many contrarian investors find solace in all the negative news and have made a living being long as the markets climb a wall of worry. Traders find themselves asking, “What strategy is appropriate given what is going on?”
Good traders should have a mental checklist of the strengths and weaknesses of all the trading strategies in their financial toolbox. When the market is falling and volatility is high, each strategy comes with its own unique concerns.
A long straddle may seem like an ideal strategy for those who believe volatility will spike. But if the markets spike higher, then the implied volatility of options will likely fall and it will be difficult to make money. The short straddle has the opposite issue because a significant loss, temporary or real, can ensue if volatility continues to increase. A vertical spread will lower your volatility exposure, but requires that you pick the right direction.
A short time spread is a great solution to the age old dilemma of what strategy to trade when the markets are making you nervous about almost everything. The easiest way to describe a short time spread is to first look at the long time spread.
A long time spread is the simultaneous sale of a short term option (to take advantage of time decay) and purchase of the same option in a back month.
Like most spreads, a time spread will only risk the initial debit. In the above example, the initial debit was $1.25.
A long time spread’s profit comes from the short near-term option decaying at a faster rate than the further out option.
There are two rules for maximizing profits on a time spread. Time spreads are worth the most when they are at-the-money (ATM), and once near the money, time spreads become more profitable as time approaches expiration.
Success depends on the stock’s volatility and how close to the underlying your strike price is at expiration. Being too far off from the correct strike on expiration will usually result in a loss.
Since each leg of the spread shares the same strike and will have intrinsic values that cancel each other out, the value of a time spread can be determined by looking at the front month’s option chain time values with one month remaining until expiration. The profit or loss of a time spread, therefore, falls under a normal distribution curve just like an option time premium.
Above is an example of the time values for an option chain with one month remaining to expiration. You will notice a tight range of profitability for a spread purchased for $1.25. If the stock closes outside the range, a loss would result, so selling the spread becomes a more feasible strategy than buying it.
“Time on your side” (below) shows the two months of a time spread overlap. As you can see, the long time spread is profitable in a stable market if you can select the correct closing range. But what should you do when the markets are in such turmoil that selecting a closing range in a stock is as difficult as selecting the winning Powerball numbers?
The short time spread becomes a powerful strategy that will allow the trader to take advantage of the high volatility. Go back and look at our breakeven/profit range for our long time spread. It is a good trade if you are confident your option will expire at or near the money. But remember our initial premise. What to do when volatility is rising and you expect more of the same. A short time spread is similar to a long straddle but without the same level of exposure. Perhaps this is why we named the short time spread “The Poor Man’s Straddle;” however, we could have just as easily called it “The Thinking Man’s Straddle." One downside to short time spreads is the large margin requirement, but there is a solution to that as well. Stay tuned.
Edward LaPorte works with Random Walk. Visit their website at RandomWalkTrading.com.