Turn the frown upside down! Options on the SPDR Gold Trust ETF (GLD) can exhibit a different type of skew structure than what other types of products display and this can lead to incremental returns to a portfolio incorporating “income” producing strategies. One strategy that can profit from elevated volatility in a skew neutral fashion is the short strangle.
A basic option pricing model assumes that volatility is a known constant. Volatility is a random variable that is a function of underlying price movements and is neither known ahead of time nor is constant. Before the advent of computers and “modern” option pricing theory, it was quite common for traders to use a constant volatility across strikes.
Essentially, traders assigned the same supply and demand factors to downside options (strikes less than the current ETF price) as they did for upside options (strikes greater than the current ETF price). In certain products, such as the SPDR S&P 500 ETF (SPY), there is a constant demand to hedge and protect long equity exposure from adverse market moves. We can refer to options on equities, because of the incessant demand for protection and the ability for a company to simply issue more equity or debt to raise capital, as supply side products.
A volatility skew, in equity and fixed-income products will be negatively sloping. Out of the money puts trade at higher volatilities than out of the money calls. Option prices are based on probability. Models are essentially giving more value, or a higher likelihood of an event happening, to downside puts.
Whether that “event” comes to fruition or not, is another story. Below is a graph of SPY options represented as a percentage (%) of moneyness. For example, the at the money option is identified as the 100% strike.
Supply-Side (Reverse) Volatility Skew
Try to remember the bell curve, or the normal distribution from statistics. Or, you may want to simply picture a “pie”. The curve is telling the model to shift to the left to give more value to out of the money puts (higher probability of outcome). The bell curve is just like one whole pie. We have not cut any pieces away from the pie, we just shifted it to the left. When we do this, we are taking away value from the right side, or in our case the out of the money calls (less probability of outcome).
Commodities, on the other hand, are demand side products. There is only a fixed amount of corn, oil, etc. and these skews will be positively sloping. Unlike stock, fear is to the upside for commodities, in other words, rising prices. With commodities, we shift our pie to the right (out of the money calls) and thus take away value from the left (out of the money puts).
Demand-Side (Forward) Volatility Skew
Volatility skews can also be referred to as smiles or smirks. One of the features of options on the ETF GLD, is neither the presence of a supply-side nor a demand-side skew. Yes, gold is a commodity, but many treat the precious metal as a hedge to equity as well. Thus, GLD options manifest the third type of volatility distribution, better known as the smile.
Volatility Smile
One option strategy that can capitalize on volatility in a slightly more skew neutral fashion is the short strangle. A short strangle involves the sale of an out of the money put and an out of the money call. The strategy is analogous to a straddle except by widening the strikes (as opposed to selling only the at the money strike in a straddle), the probability of a profitable trade improves. Options are decaying assets and the rate of daily decay is known as theta. Option theta tends to increase as expiration approaches and thus short strangles are most often employed with shorter term maturities. Short strangles can add income to portfolios, but they are certainly not riskless and are generally not suited for the novice trader. They do require active management and strict discipline in order to minimize potential losses. The best market environment for a strangle is immediately following a volatile period that morphs into a rangebound, or quiet cycle. Short strangles can be constructed with a direction neutral profile on initiation and are considered credit spreads with the intention of falling prices by either lower volatility levels and/or time decay.
One example of a short strangle on GLD is the January 20, 2017 (38 days to expiration) 107-115 strangle. As of the close on December 12, 2016, the 105 put could be sold at the bid price at $0.85 and the 115 call could be sold at $0.75, also on the bid price for a total credit of $1.60. The $1.60 represents the maximum reward for this short strangle. The strategy is not entirely skew neutral, but does have less initial skew exposure than supply-side products. If GLD remains between the two strike prices, the trader can capture the entire premium of $1.60. In reality, a prudent trader would exit this position after some acceptable capture rate was achieved, for example 50% or 60% of the premium. There is a downside breakeven point which is the lower strike less the premium collected ($105.40) and an upside breakeven point designated as the higher strike plus the premium collected ($116.60).
Short 1 GLD JAN 20, 2017 107-115 strangle @ $1.60 credit
If the ETF begins to put “pressure” on either of the break-evens, management of the position could include rolling strikes out further away or even rolling the position out in time, or just closing the position down depending upon the outlook of the trader. The critical element in using short strangles is to have your plan in place ahead of time and be prepared for unfavorable scenarios. Taking a small loss over a large loss is essential for the success of a long-term strategy.
According to Lyrics.com, there are 70 artists and 100 albums that match the phrase “Turn the Frown Upside Down.” If properly managed, the short strangle can add value to a portfolio and ultimately leave you smiling and singing to your own tune.
Chris Hausman, CMT, is Director of Risk Management and Chief Technical Strategist at Swan Global Investments, a participant in the ETF Strategist Channel.
Disclosures:
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