On May 6th, 2010 the stock market took its wildest twelve minute ride in history. SPY(SPDR S&P 500 ETF, Public, NYSE:SPY) opened at 116.26 rising as high as 117.00 before finishing the day at 112.94. Oh, I almost forgot to mention that SPY traded as low as 105.00 before rallying back up. That all happened within the in that now infamous twelve minute span of time. The VIX (CBOE: VIX) , which tracks the implied volatility of options that are traded on the SPX, was as high as 40.71 before closing at 32.80. The very next day, with the European debt situation still unresolved, the market took another beating. SPY traded as low as 109.41 before settling at 111.26.
The VIXclosed near its high at 40.95.How could a trader take advantage of the abnormally high implied volatility without exposing themselves to significant market risk? They could start buying the SPY May 112 Straddle at the close on May 7th. Before you come to the conclusion that I’m crazy and stop reading this let me tell you that there is another part of this trade. That would be selling the SPY December 124 Call and the SPY December 100 Put. The May straddle could be purchased for 6.50 while the December strangle could be sold for 11.01 for a net credit of 4.51.
The following Monday the Greek debt situation was apparently resolved. SPY opened at 115.81 and closed at 116.16. The May straddle closed at 6.04 while the December straddle closed at 9.21. The May/December strategy would have resulted in a 1.34 profit (6..04-6.50 = -.46, 11.01-9.21 = 1.80, 1.80-.46 = 1.34)
The May implied volatility was actually higher than the December implied volatility when the position was established and the trade was still profitable. That is because the dollar amount of the options sold in December was greater. When there is an overall decline in volatility the trader still benefits.
What if the market sold off instead of running up? The trader’s May 112 puts would have caused their position to get shorter and shorter on the way down. Is there any situation where this trade would not have been profitable? Yes, if SPY opened at 112.0 and just sat there. That was a possible, although highly unlikely, scenario. Additionally, the position is structured so the trader can trade around the core position since the position gets longer on the way up and shorter on the way down.
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