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An advanced strategy designed to take advantage of time decay in the S&P 500 futures option market.
Strangle Swaps: A Quick Introduction
- Strangle swaps are positions created when a trader buys an out of the money put and call and simultaneously sells an out of the money put and call in a deferred month.
- In other words, the trader acquires a short strangle that's hedged by a long strangle that's closer to expiring. Some traders refer to these positions as "reverse calendar spreads with puts and calls" or as "dual reverse calendar spreads."
- Strangle swaps earn premium for the trader if implied volatility declines. If a trader uses far out of the money options in the S&P 500, his or her strangle swaps earn positive time decay.
- Strangle swaps can be adjusted. If the underlying futures contract trends or if implied volatility rises, the position can lose money. Adjusting in the direction the market moves or buying multiple long options to create a "ratioed strangle swap" are ways to deal with these possibilities.
Strangle Swaps: A Detailed Explanation
USING STRANGLE SWAP POSITIONS IN S&P 500 FUTURES OPTIONS
Option traders and analysts are always looking for strategies that can give a high probability of success and a good return on capital, while having reasonable risk. This year's trading action in the S&P 500 options market has been a favorable environment for using a short "strangle swap" position in far out-of-the-money strikes. These types of trades have been very successful for us this year. Our continuing analysis and successful application of this trading strategy shows that they are a worthy addition to every serious option trader's arsenal. This discussion gives a general overview of the trade, as well as detailed examples of specific trades.
The short Strangle Swap trade (long the nearby strangle, short the deferred).
The position is known as a "strangle swap" on the trading floor. It might also be called a reverse calendar strangle. It involves buying a wide strangle (call and put) in the nearby month, and selling the same strangle (same strikes), in the next month out. It can involve options in two different expiration cycles. Since we are short the deferred month and bringing in a credit, we are short the spread. The unique characteristic of this trade is that with the correct selection of strikes, it is a reverse calendar trade that has positive time decay. Positive time decay means that the trade has a positive "theta," making money from the passage of time, if other factors remain neutral. Effects from implied volatility changes (vega), and market movement (delta and gamma), can also affect the profit/loss structure.
Advantages and characteristics of the trade:
- A trade that has good profit potential within a short time period, suitable for many market conditions.
- Significantly reduced margin costs over a naked short strangle. Typically, the starting margin ranges between $2500-$4000, versus $10,000-15,000 for a naked short strangle. Take advantage of margin rules.
- The ability to withstand short-term market gyrations. The trade can also be adjusted.
Some general rules: (Specific trade examples are provided later)
- The trades are initiated about 3 to 6 weeks before the expiration of the nearby month at a substantial credit, usually between 1000-2000 S&P points ($2500-$5000). Since the strikes being used are the same, the nearby options will always be cheaper than the deferred, thus resulting in a credit.
- The option strikes used are far out-of-the-money. The strikes chosen can depend on expectations for market conditions, but generally both strikes will be well over 5% away from the current market price, often over 10%. For the expected holding period, the calls will generally be about two standard deviations away from the current market price, and the puts even more. The trades may be skewed towards one side or the other, if there is a strong opinion about short-term potential for market movement. Use strikes with good liquidity. For these trades, the hundreds, quarters, and halfs are generally best (i.e. 1400, 1425, 1450, 1475, etc.)
- The intended holding period is about 2 to 4 weeks, with a profit target of about 25-50% of the original premium collected. In other words, when you put on the trade, you collect a premium, and the trading goal is to close the position at a lower price, spending 50-75% of the original premium collected. For example, if you initiate a trade at a $4000 credit (1600 SP points), and close it two weeks later by spending $2500, you've made a profit of $1500.
If market conditions are favorable, the best time to close the trades seem to be when the long options have lost almost all their value (down to about 50 points or less), and the short premium is evenly balanced. After that time, the risk/reward structure of the trade tends to become unfavorable, unless you are very confident in expecting continuing drops in implied volatility and sideways market movement.
Important market conditions to consider:
- Implied option volatility should be expected to remain flat or decline during the life of the trade. The trades have a significant negative "vega," so changes in implied volatility can have a big effect. The best time to initiate the trades is when implied volatility is relatively high, perhaps near the top a multi-week measurements. The CBOE VIX volatility index can provide a convenient reference for implied volatility conditions. It represents the market implied volatility for a basket of eight nearest-the-money options, four each in the two front months of the OEX 100, the largest index derivative contract (the OEX consists of the 100 largest stocks of the S&P 500). Examples of the VIX are shown in the charts.
- The ideal market environment is a wide, volatile trading range, which tends to keep the implied volatilities fairly high, while the market makes little net movement over time. The trading environment during 1999 has generally been very favorable. If a significant directional move is anticipated, the position can be skewed towards one side.
- Trades can be adjusted after entry, if the market conditions are right. If just a short period of time has passed, and there has been enough market movement to give good profits on one side of the trade, that side can be closed, or possibly rolled closer to the market to collect more premium.
Another alternative is to close an existing position, establishing a new trade more balanced within the expected market structure.
A unique trade characteristic:
When this trade is properly structured, it is a reverse calendar position (long the nearby, short the deferred) that has positive time decay. The reverse calendar position normally has negative time decay. Normally, a conventional option calendar trade (long the deferred, short the nearby) has positive time decay due to the accelerated decay of the nearby option. This results in profits or a "discounted" position in the deferred option after the nearby expires.
One normal use of the reverse calendar position (long the nearby option, short the deferred) is to benefit from a quick market move. If used with the long option near the money, and a quick directional move is expected, the gamma advantage of the nearby option can result in profits, since the nearby gains deltas faster than the deferred, more than compensating for the normal negative time decay. This can also result in profit with less premium outlay or margin than some other strategies. Second, if implied volatility is at an extreme and is expected to drop, reverse calendar trades can benefit from the effect of vega, which will normally have a greater adverse effect on the deferred option. In this sense, our use of the reverse calendar position is conventional, because a drop in implied volatility helps the trade.
The key to the positive time decay in these trades is the fact that they are so "wide", with the strikes far away from the market. Since the nearby options have little initial value, they simply don't have as much premium to lose, on a point or dollar basis, as the deferred options. In other words, even though the nearby options may lose a greater percentage of their value, the deferred options may lose more in premium, simply because they have significantly more value to start with. The example trades should help clarify this.
Specific trade examples follow, starting on page 3. Two specific strangle swaps are shown, as well as a recent example of why we used the call side of the trade only, and reversed the puts.
A cautionary note: Although we consider this trading strategy to be very versatile and suitable in a wide variety of market conditions with the potential for a high degree of success, it still requires analysis of current trading conditions before initiation. Always make sure that you completely understand any type of trade that you initiate, and always stick to a disciplined money management plan for risk control. Especially in the S&P, if market volatility gets really extreme, bid/ask spreads can widen considerably, and it might cost more than you think to get yourself out of a position that is going against you.
This is a position for traders who understand that it requires strict risk control. Margin will increase as the market moves toward expiration of the nearby options.
FUTURES AND OPTIONS TRADING CAN INVOLVE SUBSTANTIAL FINANCIAL RISK
Example: S&P 500 strangle swap example from 6/8/1999. This is a good example of the position, for which we have good records about the details of the trade from day to day. The June-July expiration cycle was 5 weeks.
TRADE STRATEGY/ POSITION
S&P 500 - REVERSE CALENDAR STRANGLE |
CREDIT (DEBIT) |
EXPIRE
WEEKS |
ADJUST POINTS OR RISK LEVELS
COMMENTS |
** B- JULY SP 1450 CALL & 1100 PUT/S- AUG SP 1450 CALL & 1100 PUT
(Margin about $5,000, allow $10k per position)
Margin rises as nearby expiration approaches.
Try for a credit of 1600 points or higher at entry.
At 1350 SPU, delta -7, theta +18, vega -362
Last settle 1600 points with SPU 134560 |
$4000+
(profit target is to collect $750-1000) |
N=5.5
Q=10.5 |
Note: The maximum hold period is until July expiration, but 2-3 weeks is expected. Use strict risk control.
For the first week, an adjustment can be considered to "roll" one side in to collect more premium. Risk $1000 drawdown from entry, or evaluate adjustment then. |
TRADING COMMENTS - We first implemented this strategy successfully in the January 26 hotline, watched several subsequent positions on in-house trades, and established another position in the May 25 hotline. These trades are an unusual situation in a reverse calendar position in that they tend to have positive time decay. After several months of watching how the trades perform, we're impressed with the fact that they have been able to work in some fairly volatile market conditions.
For a new position, consider the reverse calendar strangle in the July/August options with the strikes specified in the recommended positions table. The recommended credit is 1600 points or more. We got a 1600/1700 bid/ask from the floor during Monday's trading with the SP near current levels. The margin is about $5,000 to start, and we recommend allowing $10,000 margin per position. The longest hold period would be until expiration of the July options, but we will be hoping to achieve the profit target within two to three weeks, as in the recent trade. Suggested risk is at about $1000 drawdown, at which point the trade should be closed, or evaluated for adjustment. We have found that if the market moves far enough shortly after the trade is placed, sometimes the side that has gained can be rolled in tighter to collect more premium, or the entire position rolled to achieve better balance in the market.
This chart of the September S&P market shows the trade evaluation and entry area, and the time when profits were starting to be taken.
June 22 hotline comment (excerpt): In the S&P 500, we're not taking new positions in the July/August reverse calendar strangle trades this week because volatility has dropped to very low levels, and it is reflected in the far out-of-the-money options. Two weeks ago, we used a trade that combined the 1450 call with the 1100 put, and then last week we used the 1425 call with the 1100 put. Volatility in both puts and calls in these positions has dropped over two full percentage points since just last week. That has worked in our favor, as the trades have a negative vega.
During yesterday's late strength in the market, we used the opportunity to close the put sides of some of these positions, and we would continue to do so. In the July/August reverse calendar strangle positions using the 1100 puts, close the put side of the spread for 350 points better. It settled yesterday at 345 points. In other words, you would be buying back the August 1100 put to close, and selling the July 1100 put to close, for a total debit of 350 points. This will leave the reverse call calendar spreads in place, with either the 1425 or 1450 strikes. The idea is to either close the call side of the trades on the next dip, or resell the put side if the volatility and premium make it worthwhile.
By the way, if the market had moved down and given us a gain on the call side of the spread, and option volatility had increased, we would be more likely to simply roll down the call side of the spread to bring in more premium credit. However, since implied volatility is dropping, we don't want to sell a new calendar spread into low volatility. Of course volatility could go lower, but we'd rather sell volatility near the highs of its trading range, and buy it on the dips. The chart of the VIX index below makes the point. Even though the volatility changes in the far out-of-the-money options have not been as dramatic as the at-the-money, it has still been affected.
June 29 hotline comment (excerpt): We recommend closing the remaining call spreads in these positions, taking available profits. (If not done already)
The following spreadsheet shows each day's closing values for the spread since the evaluation date.
Trade position: Buy July SP 1450 call & 1100 put/Sell August SP 1450 call & 1100 put
Closing prices on June 7, evaluation date: (Both options contracts index to Sep futures)
SPU = 134560 Q 1450 call = 1320 points, Q 1100 put = 840 points
N 1450 call = 310 points, N 1100 put = 250 points
Total spread value, 6/7 close = (1320+840) - (310+250) = 2160 - 560 = 1600 points credit
Greek Values: Delta -6, Gamma -.02, Theta +31, Vega -341
Margin at initiation about $2500. Moved up to about $4500 in three weeks.
Following trade actions:
- On June 22, close the put side of the trade for 350 points. It settled at 300 points.
- Close the calls on the next dip.
- June 29, close the call side of the trade (if not done). Settled at 665. It had been as low as 280 on 6/25.
- Total cost to buy back the two reverse calendar spreads should have been no more than 1000 points.
- With an entry credit of about 1400 points, profit targets were achieved.
How to calculate the trade value: On a daily basis, record the values of the options involved in the trade. The spreadsheet above shows an example. For instance, let's use the closing values on June 8, the day of the hotline, which is the second row of numbers. The August calls and puts total value was 1940 points (1080+860). The July values were 480 points (210+270). Subtract 480 (your long option premium), from 1940 (short option premium), to get a credit of 1460 points. 1460 x $2.50/point = $3650 credit.
S&P 500 September futures with daily CBOE VIX volatility index.
S&P 500 cash index with daily CBOE VIX volatility index.
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