Short straddle in FAS

On Feb 10, 2009 I sold a straddle in FAS over the FEB 10 strike and received a credit of $3.05

FAS is the 3-times leveraged Financial ETF. It’s sister is FAZ, which is basically the short version of FAS. Well, before Geithner’s debut, the volatility on FAS was running around 250%. I’ll be honest, it looked like something that needed to be sold. So I put in an offer at the mid price and got filled immediately. That’s never a good sign. I immediately began second-guessing myself. Hmmm.

A short straddle is a short put and a short call over the same strike. Most retail traders prefer to BUY a straddle and they learn that their risk is limited to what they paid and their profit potential is unlimited to the upside, and limited to zero on the downside. It’s a common retail mistake to buy straddles ahead of earnings thinking they are getting a deal. What they fail to recognize is that the market has priced in the uncertainty, and most long straddles lose money. Those taking the other side of the trade, the straddle sellers, have the odds on their side, just like Vegas.

On my FAS short straddle over the 10 strike, I sold a call and a put at the 10 strike. My break-even is easy to calculate. On the call side it’s 10 plus the credit, or $13.05. On the down side it’s 10 minus the credit or $6.95. I took a trade that wins if FAS settles between $6.95 and $10.05 by FEB expiration, which is next week.

If FAS settles below around $7 by FEB expiry, I am the owner of FAS stock (100 shares per contract) after the holder of the 10 put exercises his rights against me.

If FAS settles above around $13 by FEB expiry, I am short FAS stock after the 10 call holder exercises and get hurt if it keeps going up, theoretically up to infinity.

So the plan is to let this hyperstock calm down, and buy back the straddle for less than the $3.05 I got in credit, thereby milking a profit. After the first day, the trade was up $0.40. But I have a hard time sleeping at night with a naked straddle so I woke the next day with a plan to define my risk.

I am going to buy protection in MAR that will hedge my high volatility sale in FEB. I’m really more concerned about a crazy rally to the upside (remember that’s where the risk is infinity). So I need to buy the MAR 10 call, and essentially create a calendar. On the put side, the most I could lose is about $7. And if FAS goes to zero, I’ll have bigger problems to worry about, such as stockpiling for Armageddon. So, I’ll settle for purchasing the 7.5 put in MAR. And guess what? The cost of that long straddle (strangle with wider strikes) was exactly $3.05, equal to my initial credit.

I have no risk to the upside, and $2.50 risk on the downside. This assumes I roll my FEB short strikes into MAR, which is what the plan is. After I do, I will have a credit for some amount (depends on when I roll next week). The calls will cancel each other out, and the puts will create a short put spread with strikes of 7.5 and 10. My trade is a winner if FAS closes above 10 by Mar expiry, which is March 20, 2009.

This trade has maximum profit potential if the price of FAS moves to my short strikes next week. Remember that when trading option spreads, you want the underlying to go to your short strike.

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