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Quad Witching and Trading Straddles

Coming off of a break and noticed the market has shed a few pounds. I thought it might be a good time to look at the premium buying side of the options equation coming into expiration. The famed "Quadruple Witching" trading occurs when stock index future contracts expire (they trade quarterly March, June, September and December) with the standard options expiration on the third Friday of the month. Traders have to "roll" their futures positions and deal with the expiring side of the options contracts. What this makes for is a very messy expiration week as liquidity bulges in fits and starts and it kicks up the short-term volatility of the underlying instruments (this is measured by historical volatility, specifically the 10-day or HV10). Larger swings in the traded index names are much more possible during this week since there are more "mechanical" forces at work.

The key is traders have to be more cognizant of how they close positions. Since more volatility is expected it might be better to close short contracts expiring in June a bit more early than normal because of the expected volatility. On the flip side, long options premium trades may get a new lease on life through the end of the week. Just something to keep in mind during this week and the increased action last week helped our Kulicke and Soffa Industries (KLIC - Get Report) straddle.

Trading KLIC Straddles

I recommended a low implied volatility straddle in KLIC a few weeks back, and as is the way with buying premium sometimes, the name did not do much and decay started to attack the value of the straddle. A straddle is a trade that rises in value if the stock moves up or down as long as the underlying movement is larger than the daily decay. The idea with buying premium is a two-fold approach: namely the stock moves in one direction at once (increasing the straddle value between the purchase time and expiration) or trading the change in deltas of the straddle. Pretty much everyone gets the first scenario so I will spend a bit of time explaining the second.

Buying an at-the-money straddle (buying 1 call and 1 put, same strike, same month) has a near 0 net delta (50 delta for the call and -50 for the put for a net 0). This means the trade is balanced at the strike and neutral as far as direction goes (at the outset). As soon as the underlying moves, the position changes character in that the trade gets "longer" or "shorter" depending on the movement. In the KLIC July 12 straddle trade, after a brief pop up early, the name started sinking getting all the way down to $10.07 as of last week. What happened to the value of the calls and the puts? The calls went to around $0.10 and the puts to around $2.00 leaving the value near where you put it on (one subscriber sold the puts out for a slight win). But what is the "delta" of the trade? The calls were a 10 delta and the puts a 90 delta leaving the position short 80 deltas for every one lot straddle at $10.07. There are choices here:

Buy stock against the position to be delta neutral (80 shares per straddle), and this in effect sells out a portion of your short puts for the intrinsic value of the trade. With the July 12 straddle, a $10.07 delta neutral stock purchase means you sold 80% of your put position for $1.93 (12 Strike - Stock Price = 12 - 10.07 = $1.93). The net effect would be you increased your number of long calls by 80%. Remember -- buying 100 shares of stock has the synthetic equivalent of one long call and one short put. Now the position is geared for the upside for very little cost. The position has 20 deltas left of "short delta" potential to buy in if KLIC continues to decline (the puts can still go to -100 deltas, calls to 0 deltas). When you buy stock against puts, you can only lose the premium over parity (the formula for premium over parity for puts is (stock price + premium - strike price). In the example above that is a $0.07 debit.

OR

Sell the number of puts to get delta neutral to reduce the leverage in the position and capture the small gain. The position is still left with long calls for an upside ride. By selling all the puts the position is now delta "long" by the delta x the number of calls owned. I recommended three straddles in my post so this would be 30 long deltas total. If KLIC skips back up to $12.75, or better, you are off to the races. Let's see if the volatility this week can kick things around a bit.

A couple of things here that are important to make this work. Namely a working knowledge of deltas (lots of quality descriptions in OP by the contributors) and owning enough contracts to trade. I usually recommend three-lot minimums on straddles because of the flexibility needed to adjust deltas with options (I think many subscribers are unfamiliar with stock adjustments but it is pretty common for proprietary trading shops). This is a good start to learning how to trade straddles. I hope it helps.

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