STRADDLE WRITING
Q. How does the level of volatility play into whether this strategy will provide positive investment returns relative to the market in general?
A. Please note that the following statement is contained in Chapter 5 of Short Spider Straddles: "Since volatility is a key factor in option premium prices, what the future holds for this strategy will largely depend on levels of volatility. We have seen that the higher the VIX (within the range of 20 to 30), the more profitable this strategy will likely be. If the VIX reverts to long-term historic norms at the 20 level, this strategy will likely be less profitable, but will still exceed the level of returns available by most alternative measures. Fortunately there is nothing that locks an investor into this strategy. We have the opportunity to measure the VIX and our investment results using this straddle strategy on a monthly, even a daily basis. If the returns stop being attractive and other better alternatives present themselves, we can simply stop using this strategy and begin using other ones." The historical data provided in the book points to increasingly smaller returns as the VIX declines below the 20 level. Should the current extremely low level continue, investors using this program may wish to consider the suitability of utilizing this strategy until VIX levels resume to a range above the 20 level.
Q. Shortly after writing a straddle, if there is a significant move in the market so that either the put or the call could be bought back very cheaply, would it make sense to do that since most of the gain on that option could be captured very quickly?
A. There is no simple answer to this question. If you knew what the price of the underlying security was going to do during the balance of the time until expiration, then you would know whether that would make sense or not. Since only one margin requirement is needed to support both the put and the call option position, the margin requirement would not be reduced by buying back the lowest price option position. If it would be your intent to replace the repurchased option position by another strike price that is closer to the market of the underlying shares to increase premium income, doing so might make some sense, however you are assuming additional risk in case the market moves against you. The statistics in Short Spider Straddles assumes that both the put and the call position are held until expiration day. Any deviation from that would invalidate the historical data presented in that book. Highly sophisticated investors, however, may decide to experiment with alternatives to the program as it is presented in the book.
Q. If I were going to write a straddle when the SPY is at, say $90.49, would it make sense to write a $90 put and a $91 call instead of writing both legs of the straddle at a $90 strike price?
A. The statistics in Short Spider Straddles assumes that both the put and the call position are held until the end of expiration day. Any deviation from that would invalidate the historical data presented in that book. However, when the market price of SPY is about halfway between two strike prices, it would not be unreasonable to do what you have suggested. The total premium you would collect would be reduced a bit (in your example, on the $91 call) and your return for that month would be affected (either positively or negatively, depending on the closing price at expiration). Nonetheless, if you were fortunate enough to have the market price of SPY between $90 and $91 on close of expiration day, you would retain all of both premiums.
Q. Do you have a general rule-of-thumb that you use to calculate an amount of excess margin coverage above and beyond the amount calculated by the model that you use when you establish the trade? For example, if the model calculated the amount of margin required to support the straddle to be $20,000, would you add another $2,000 or $4,000 to keep from having to deal with potential margin calls?
A. If you look at the "straddles" Excel template that comes with the book you will see in cell R6 that the margin requirement has been set at 30%, which is typically conservative. I believe most brokers only require a 25% margin under the second calculation method used in the template, which is the one that will apply when writing straddles. Thus, if you leave that cell at 30% you should have a 20% buffer to work with. That should do under most circumstances unless you get a very large swing up or down in the SPY during a cycle. What you could do is insert the current data into the "straddles" template to see the amount of the margin requirement for a particular deal, then change cell R6 to 25% and change the SPY quote up or down by 10 points or so, also changing the option premium to an estimated amount to reflect the change in SPY price. That would give you the approximate margin requirement under a scenario that should normally cover you. That's not to say you will never get a margin call, but it would require a pretty decent swing before that should happen.
Q. I'm always struggling between writing "straddles" (using the same strike price for the put and the call) and writing "strangles" (using different strike prices). I read in one of your Q & A's that you're not opposed to writing strangles on SPY (e.g., when answering a question on writing the $91 call and $90 put when SPY is at $90.49. In fact, I've been writing strangles for years but very seldom writing straddles, as I'm more conservative...I'd rather collect less but surer premiums. It's been working well for me for a long time. Of course, the gain is limited as well, because far less premiums are collected upfront than with selling straddles if both the put and the call are well out of the money. But with margin, I can consistently earn at least 30% plus return year after year. I would really appreciate it if you could shed some light on whether you would prefer writing straddles or strangles and your reasoning.
A. I have absolutely nothing against strangle writing and I have used it extensively myself. Another book I've authored, Writing Uncovered Put and Call Combinations, focuses exclusively on strangle writing. While you have a window of opportunity within a strangle that can go beyond a straddle, the problem is that if the volatility of the underlying shares causes the price to go beyond the put or the call strike price, unless you get out you face some potential huge losses (e.g., the Google example on the naked call side that I discuss in my combinations book). The use of the Spider straddle is predicated on historical data and the assumption that it is impossible for anyone to determine where the market is going. Therefore, based on this historical data provided with the book, a strategy that maximizes the combined put and call premiums should work best in the long term for an investor that is not able to predict such movements correctly. If you can predict the direction of markets or underlying shares, then you will obviously be in a position to make decisions that will outperform. The fact that something like 80% of all managed mutual fund advisors don't even outperform the S&P 500 suggests that few people have the ability to regularly outguess where share prices are headed. Clearly one of the most important things for investors is to be consistent with whatever they are doing and fully understand what they are doing and why.
Q. Can you comment on rolling up and rolling down the strike prices with the Spider straddles program outlined in your book. Would doing this work?
A. All of the data I present in the Short Spider Straddles book is based on the assumption that you establish the short and long position and just sit on it until expiration is about to occur. If you were to roll up or down, then the data would no longer be relevant to the positions you've established. That's not to say it wouldn't work. If you guess right when you roll in either direction, then you will do better than the program that is outlined in the book. If you guess wrong, then you'll fare worse. A major advantage of the program as outlined in the book is to eliminate the guesswork to achieve more predictable returns based on a substantial amount of actual results based on price history. So there's nothing inherently wrong with rolling up or down if you want to play it that way. It just invalidates the historical data.
Q. I just saw something happen to an option that I’d never seen before. Due to a special distribution (dividend) of one of its component holdings, the Oil Services HOLDRS (OIH) had the strike price of all of its May expiration options reduced by $0.15. In other words, my original $130 strike price on my May covered calls is now $129.85. Have you ever seen anything like this happen? While this isn’t particularly problematic in a covered calls portfolio (other than losing the $0.15 if assigned), it does potentially take on a lot of importance in the SPY straddle portfolio. If you weren’t paying attention and missed the strike price adjustment, you could get in trouble when you close out the in-the-money leg, since you’d be making decisions based on inaccurate strike price assumptions.
A. The only time I've ever seen this happen before was when Microsoft declared a very large special dividend sometime back. Strike prices were adjusted significantly to reflect the payment. There are very few special dividends, so it is not often an issue. With the SPY, such a special dividend by one company would have little effect, if any, on the overall strike price, but as you pointed out it would still be an issue that one would need to be aware of. It should never be applicable to regular dividends. I would assume that the numbers in the strike prices would all have to be changed and it would be noticed if one regularly watched the option chains. While I don't anticipate it to be any issue of significance, it's just another thing that an investor may want to monitor from time to time before closing out a position.
