The straddle‐buying hedge By Richard Croft July 16, 2012– I’ve been doing some research on the prospects of buying close-to-the- money straddles. Actually I dusted off studies I had done a number of years ago and surprisingly – or perhaps not – the results today were very similar to previous iterations. More to the point, the results seem to be the same in virtually all market environments. A long straddle is a non-directional volatility trade that profits when the market moves sharply up or down, when volatility expands, and in particular as a hedge during significant market declines. In markets where uncertainty creates noise and where noise creates expanded trading ranges, any hedge is probably a good thing. What I was looking for is whether straddle buying was a reasonable strategy. Some years ago I developed the Covered Straddle Writers’ index for the Mx (symbol MPCX). The MPCX involves the simultaneous sale of close-to-the-money calls and close-to-the- money puts against a long position in the iShares of the CDN S&P/TSX 60 Fund (symbol XIU) and a cash position used to secure the short put option. The near-term (i.e. one month) close-to-the-money call and put options are written each month, on the Monday following expiration, and are held until the following expiration. At expiration the written options are settled for cash, and on the following Monday, new one-month close-to-the-money calls and puts are written against the underlying iShares of the CDN S&P/TSX 60 Fund and cash. The cash component in the strategy earns interest at the prevailing market rate for 90-day Treasury bills. The MPCX has shown to be a profitable strategy over the past 15 years. My challenge was trying to understand why anyone would buy straddles if history shows that straddle writing is the more profitable approach. Of course that same conundrum applies to covered call writing which has produced alpha in most market environments leading one to ask why buy calls? The trick is to understand the difference between an investor who utilizes option writing strategies – i.e. covered calls, short straddles, etc. – and a trader who goes long options. As the names imply, the investor is likely selling options and holding the position to expiry. That is the underlying premise behind the Mx Covered Call Writers’ Index and © 2012 by R.N. Croft Financial Group Inc. Page 1 the Mx Covered Straddle Writers’ Index. In both indexes, the positions are held to expiry at which time they are settled for cash and a new position is implemented. Traders on the other hand, rarely hold long positions until expiry. Generally traders move in and out of positions frequently over very short periods. And that got me to thinking about what happens to the straddle prior to expiry. Is there a point between initiation and expiry where the straddle is profitable? And how frequently does that event occur. Interestingly, when you consider long straddles from that angle there is often a point prior to expiry where the straddle can be closed at a profit. The study that I worked on utilized the data from the Mx Covered Straddle Writers’ Index going back to March 1997. The study assumed a $100,000 portfolio that included the long straddle combined with short term treasury bills earning the risk free rate. The trader would deploy approximately 5% of the capital to purchase each 90 day straddle and if there was a closing value prior to expiration where the straddle was profitable, the position would be closed and a new position would be entered on the Monday following the normal expiration of the initial straddle. In the 15 years since March 1997, a trader could have purchased sixty 90 day straddles of which 91.67% of the positions could have been closed out with a profit prior to expiration. Now having a 91.67% success rate does not imply that the strategy is successful. It simply means that 91.67% of the positions could have been closed out with a minimum 1% profit. However, that model is fatally flawed because a 1% return 80% of the time is not enough to compensate for the losses from the remaining 20%. Our hypothetical $100,000 portfolio following the aforementioned strategy would have been worth $53,723 fifteen years later. To make this a profitable strategy one needs to find an optimal point at which to exit a profitable position. In other words what rate of return is required and how frequently is that return expected to occur. The minimum acceptable return is 13.45% which would deliver a profitable straddle 81.67% of the time but over the last 15 years fifteen would have simply maintained the value of the portfolio. Moving up the performance ladder the most profitable model was one in which the minimum return assumption was set at 85% which occurred 31.67% of the time. That generated an end portfolio value of $262,792. But the optimum model seemed to be one where the minimum return assumption was set at 50% which occurred 51.67% of the time during the last 15 years. That model generated an end value of the portfolio of $218,792. For comparative purposes, $100,000 invested in the XIU would have returned $225,792 (not including re-invested dividends). The straddle / XIU comparisons offer another conclusion for investors seeking alpha. Consider straddle buying as a positive long term hedge within an all equity mandate. A straddle, like volatility, has a low and sometimes negative correlation to an equity © 2012 by R.N. Croft Financial Group Inc. Page 2 mandate. When you combine straddle buying within an equity mandate you reduce risk. Sometimes significantly! Suppose for example that you employed the 50% return assumption using 5% capital to invest in each straddle resulted in an annual standard deviation of 11.12%. Now let’s assume you own a portfolio of Canadian stocks that are highly correlated to the XIU. Over the past 15 years that portfolio likely experienced an annual standard deviation of 20.01%. Now if you had purchase a portfolio split equally between straddle buying and Canadian equity and assuming that the portfolio was re-balanced annually, the standard deviation over the past 15 years would have come in at 11.27%. Moreover, the combined portfolio would have generated an end value of $248,815 which is greater than the end values for the component parts. And that is the magic of portfolio optimization where negatively correlated profitable entities when combined produce an efficient portfolio that results in alpha! What have you actually constructed in terms of a combined portfolio? When you break out the component parts, the combined portfolio is approximately 50% equity, 40% treasury bills and 20% straddle buying. When you think about it, this portfolio resembles a typical balanced portfolio made up of 50% equity, 40% bonds and 10% cash.■ Please visit our website for more timely information on the markets, financial planning, and new products from R.N. Croft Financial Group Inc. www.croftgroup.com © 2012 by R.N. Croft Financial Group Inc. Page 3 .