The short straddle

November 27, 2015 11:00 AM

During the past year GLD traded between 103.25 and 125.58, and that range has grown even tighter in the past six months. The range actually  has greatly narrowed during the last 10 years. There is no real trend in gold. When the market is congested, trading gold futures or ETFs doesn’t reap big profits. However, selling time value does work. 

Let’s take a look at the January GLD options. A key options strategy for a churning market is the short straddle. When you straddle a fence you’re not sure which side you want to find yourself. A long straddle is a great strategy if you believe that there will be a big move but you’re unsure of direction. You are buying at-the-money calls and puts. A short straddle, selling at-the-money options, works when you think the market will be relatively range bound. All options lose time value as they near expiration. The January 110 straddle is closest to at-the-money. Its bid ask spread is 8.65 – 8.85. A credit of $865 is accrued for each short straddle. That works out to be an implied volatility (IV) of 17.65%. Between Sept. 25 and Jan. 15 the expected range will be between $101.25 and $118.75. If some big news hits, the straddle would be priced higher and the IV would increase. If the congestion tightens then the straddle will decrease in price with the IV declining. That is a less likely result because of the present low level of IV in GLD. Assuming all other things being equal the value of the straddle will decline daily at an approximate rate of 0.04. If you are short a 10-lot that will be a profit of $40. The decay for the December, November and October straddles would be $45, $53 and $81 respectively. Options decay at an exponential rate. For example, October options that expire in five days of this writing would decay by $190 in one day.  

The biggest liability in this position is any move away from the strike price, especially a gap move. You first want to determine if a gap move is more likely to happen to the upside or the downside. The IV for the January 100 puts is 19.16% and the IV for the January 120 calls is 19.30%. If you do choose to hedge the straddle keep in mind that GLD moves with equal speed to the upside and downside. Its options have a flat skew. You could establish a position in the January 100 put-January 120 call strangle for 2.65. That would reduce your maximum profit, at 110 at expiration, from 8.65 to 6.00. You have defined your maximum loss. Instead of unlimited possible losses to the upside, the maximum loss is 4.00.  The maximum loss to the downside is trimmed from 101.35 to 4.00. You have become short the January 110-100 put spread along with being short the 110-120 call spread. Each of those spreads has a maximum value of 10.00. Subtracting the credit you receive from the maximum value gives you the maximum loss (see “Profit/loss scenarios”).

You can see in the first chart that at expiration the upside breakeven point is $118.65 and the downside breakeven point is $101.35. Maximum losses begin at 120 to the upside and 100 to the downside. Before expiration you start losing money in a much narrower range. If GLD starts trending to the upside you should look to hedge the position with a trade that benefits from an upside move. Shorting the GLD January 105-101 put spread would be one move that you can make. It would alter the profit/loss skew as shown in the second image. 

Likewise, if GLD starts trending to the downside you should look to hedging the position with a trade that benefits from a downside move. Shorting the GLD January 115-119 call spread is a strategy that would work as shown in the third image of “Profit/loss scenarios.”

About the Author

Dan Keegan is an experienced options instructor and founder of the options education site optionthinker.