| Let's use the two index ETFs, the SPDR (SPY - news - Cramer's Take) and DIAMONDS (DIA - news - Cramer's Take), to trade the two indices. On July 7, the SPDR closed at $126.61 and the DIAMONDS at $110.96. We can use the August $126 strike for the short SPDR straddle, and let's use the August $109 puts and $113 calls for the long DIAMONDS strangle.
Now comes the tricky part. Given the larger dollar value of the SPDR, we should trade 1.14 times the exposure on the DIAMONDS to make them dollar-equal. And the net delta, or expected movement of the option price against the stock prices, should be as close to zero at initiation as possible. The idea is to trade volatility, not stock-price movement. The initial deltas of the options are:
SPY $126 call: .6006 SPY $126 put: -.4163
DIA $113 call: .3606 DIA $109 put: -.3195
As a short SPDR $126 straddle would have an initial delta of -.1843 and the long DIAMOND strangle would have an initial delta of .0411, we would be taking a net short directional position on the market if we did not trade more DIAMOND strangles. Adding the size and delta factors together, we should do the following trade:
Buy 5 Aug 113 DIA calls and 5 Aug 109 DIA puts at a net debit of 5 * ($1.05/call + $1.15/put) * 100 = $1,100
Sell 1 Aug 126 SPY call and 1 Aug 126 SPY put at a net credit of 1 * ($3.00/call + $1.70/put) * 100 = $470
What will this trade look like over price and time, assuming a continuation of the 1.021725 elasticity and constant implied volatilities for both the SPDR and DIAMONDS? It should look like a long straddle, as any move away from the current $126.61 price of the SPDR will lead to expected higher gains on the DIAMONDS strangle. It also should suffer from time decay as expiration approaches. In the illustration below, both factors apply. |
