Selling ATM Straddles Around the Fiscal Cliff Could've Netted Traders 36%
Selling the "at the money" (ATM) straddle in the S&P 500 ETF (NYSE: SPY) during the countdown to the fiscal cliff may have put some grey hair on the head of many a trader, but it put green in the pockets of those who did it.
In that case, traders might have learned an important lesson: be skeptical of widespread media-pumped events.
The short straddle is a relatively simple options strategy that involves taking in a credit in exchange for unlimited risk.
The short put and call create a buffer of premium, as the underlying asset churns around and tests profit and loss points. Prices above the strike price, plus the credit received, represent losses as result of a rally. Prices below the strike price, minus the credit received, represent losses as a result of a drop. Prices inside these two bounds are profit.
Market participants and pundits alike were nervous nellies going into this catalyst. The thought behind selling volatility into an uncertain event is a rather dangerous proposition; yet it paid off.
If an investor decided to fade (sell) this event, a possible strategy could have been the aforementioned options spread. Looking at historical options data, if investors had sold the weekly ATM straddle in the SPY every Thursday during December, when new weekly options had about eight days until expiration, the result was an impressive $4.45 points in the SPY or $445 on one contract trades.
December was home to heated fiscal cliff rhetoric from both sides of the political spectrum. Considering that this series of trades was over a month, the annualized gain was over 36 percent.
The results and implications from this exercise are rather profound. The media tends to hype up events like this, so much so that perhaps market prices inflate to reflect this reality.
Nothing sells like fear -- television ratings and revenues depend on captivating audiences at nearly any cost. Considering that government tends to drag their feet when it comes to difficult decisions, an extension and last minute deal should have been expected.
Uncertain events do indeed propagate increased premiums, however a keen trader with a skeptical eye could identify opportunities like this to exploit. The risk was indeed rather large and not suitable for most traders, but the reward was enormous and the learning experience priceless. Fool me once, shame on you; fool me twice, shame on me.
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