Straddles 101 — XLF Case Study
A bold trade is being initiated in the SPDR Financials (XLF) today. Shares are up 6 cents to $14.03 and have rallied 5 percent since Monday. One player in the options market seems to be anticipating additional volatility in the banks and brokers. 20,000 July 14 straddles were bought on the ETF for $1.09 per straddle. More than 45,000 have traded on the session — making the July 14 puts and calls on XLF among the most active options today.
If it’s an opening play (and it might be closing), the straddle buyer is anticipating a substantial move higher or lower in the financials over the next six weeks. In this strategy, the investor bought July 14 puts on XLF for 61 cents per contract and bought July 14 calls for 48 cents. The total premium purchase is $1.09. The breakeven of a straddle at expiration is always the strike price plus and minus the debit. In this case, the breakevens are $12.91 and $15.09, or 7.5 percent below and 8.2 percent above the current spot price.
It’s a bold trade because of time decay. Both of the puts and calls will be losing value due to time decay (vega), with the entire debit at risk if shares settle around current levels. At $14 in 42 days, both the puts and calls expire worthless and the debit is lost. On 20,000 straddles for $1.09, the total premium is $2.2 million.
Another important consideration is implied volatility. 30-day at-the-money implied volatility in XLF is up .5 to 27.5 and roughly midway between the 2012 high and low of 34.5 (Monday) and 18.5 (3/26). If implied volatility moves higher, the straddle buyer benefits. Falling IV hurts the position. The key to success when buying straddles is for the magnitude of the move (delta) in the underlying stock, ETF, index or futures contract to be sufficient enough to offset the negative impact of time decay. It doesn’t matter if the move is higher or lower.Changes in IV can help or hurt the straddle buyer.
Category: All ETFs, Trading Education
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About the Author (Author Profile)
Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.
