Trading Straddles in /ES

In last week’s Portfolio Analysis I briefly discussed an at-the-money straddle that I sold last week in /ES which proved to be extremely profitable. Today, I opened another /ES straddle, this time placing a protective put since I think this market still has significant downside risk.

Before I discuss this specific trade, I will first provide some background and context.

I cannot take credit for the idea of trading staddles on /ES. At first glance, a straddle using options on the S&P 500 futures contract in this volatile environment might seem like portfolio suicide. In fact, I would have never considered taking this trade had it not been for a segment recently on Tastytrade. Before trading this strategy, I would encourage you to view the Rising Star interview with Craig by clicking here. Craig and I have corresponded both by email and telephone on various subjects and I can assure the readers of this blog that he is the real deal.

The straddles have resulted in phenomenal returns in the sideways market that we have experienced for most of 2015. That really is the perfect environment for a straddle whether on an index or an individual stock. However, with the huge expansion in volatility, these trades can still be very profitable because it does not take much of a contraction in volatility to result in a healthy profit. For example, last Tuesday when I sold the Oct 1920 straddle for $136 ($6,800 premium received), the /ES December futures contract was trading at 1917 and the implied volatility on the option chain was 31.4%. When I purchased the straddle back on Friday, the /ES December futures contract had dropped to 1908.50, away from my short strikes. Yet, I was able to purchase back the straddle for $122 ($6,100) booking a profit of $700. This was possible because the implied volatility dropped to 27.76% on the options. A drop of 3.64% in implied volatility allowed for a huge profit in a very short period of time despite the index moving away from the strikes.

Let’s take a look at the trade I placed today.

Trade Details:

SELL 1 /ES Oct 15 1920 Call @ 60.50
SELL 1 /ES Oct 15 1920 Put @ 59.00
BUY 1 /ES Oct 15 1840 Put @ 35.00

Credit: 84.50 ($4,225 per contract)
Max Risk: $0 on the downside; Unlimited on the upside (above 2004.50)
Margin Required: $3,630
Days to Expiration: 39

With the possibility of a re-test of August 24th lows (or perhaps even the Oct 15, 2014 lows), I modified the straddle slightly by purchasing an out-of-the-money put. Since the premium received for the entire trade is greater than the width of the put spread, there is no downside risk. In fact, the minimum profit on the downside is $225 no matter how low the S&P goes. The risk is to the upside, however as the market rallies, volatility will collapse and I will be able to exit profitably long before it gets to that point. Here is the risk profile for the trade:

Analyze_090715_ES

I will look to close the trade somewhere between 10-25% of max potential profit.

Before wrapping this up, I would also like to briefly explore the SKEW. The SKEW is an indicator that I look at frequently and have mentioned previously in this blog. The value of SKEW increases with the tail risk of S&P 500 returns. When there is no tail risk, SKEW is equal to 100. Historically, SKEW has varied between 100 and 150 with the average being 115. This table illustrates the probabilities of returns two and three standard deviations below the mean. Close to 100, the probability of a crash remains very small. As the SKEW rises, the probability increases.

SKEW Values

If we look at the current value of the SKEW, it closed Friday at 142.19. The last time the SKEW was this high was on September 19, 2014, just before the market began a major selloff.

Chart_090715_SKEW

This does not, of course, guarantee that the market is going to continue sliding downwards, but it is a fairly reliable indicator of past market declines and is specifically the reason that I chose to add the protective put in the straddle trade placed today.

Enjoy the rest of the holiday and happy trading!

laborday