Monthly Archives: December 2012

The Long Straddle and the Fiscal Cliff

The long straddle is a strategy that can be employed prior to the release of a significant news announcement. One time might be when government economic reports like the GDP or unemployment numbers are about to be released.

The way the strategy works is pretty simple. We know that there is going to be some news that could affect the market. We don’t know what’s in the news or how the market will react. To be prepared for a big market move in either direction we decide to purchase a long straddle on the SPY which is the ETF that represents the S&P 500 index.

To purchase a straddle you buy an equal number of calls and puts at the same strike price which is at the money. At the time of this writing the SPY is at 140.96 so I have illustrated a 141 straddle. I am showing the Jan 19th expiration. The straddle will cost $5.00 to purchase and that is the maximum risk. If held until expiration the break even points are $146 and $136.

With the fiscal cliff talks going on congress could make an announcement anytime. Right now the house is planning to convene on Sunday, so they could have an announcement prior to the market open on Monday. A long straddle purchased before the weekend could be profitable if the market has a big gap open on Monday after congress meets.

If the straddle is held longer than a couple of days, the investor can employ a “gamma scalping” strategy to offset the option decay as measured by the position’s theta.

Below is an illustration of the P&L graph for the SPY Jan 19, 141 straddle.

SPY ATM straddle 12-28-12

Special Dividends and Option Contract Adjustments

There are times when option contracts are adjusted for corporate events like stock splits or special dividends.  In the case of a 2-1 stock split for example, the option contract strike price is adjusted in half and the number of contracts doubled.

There is no contract adjustment for ordinary dividends. Regular dividends that are paid on a quarterly basis are factored into the option’s price. When a stock goes ex-dividend the stock’s price is adjusted by the amount of the dividend. The call and put option’s price reflects the amount of the dividend.

Due to the ongoing fiscal cliff negotiations, many companies are opting to pay out special dividends this year before the anticipated increase in the dividend tax rate. Currently dividends get a special tax rate of 15%. That rate could go as high as 39.6% in 2013 depending on the outcome of the fiscal cliff negotiations. Campbell soup became the last major company to declare a special dividend. Over 100 companies with a market cap greater than $240 million have declared special dividends this year. The total value of all the dividends is almost $23 billion.

If you’re using a covered call or a collar strategy to collect dividends, remember that with these special dividends, the strike price will be adjusted downward to reflect the special dividend unlike the ordinary dividend.

Option Chain for Boise showing Strikes reduced by $0.72 foe dividend.

Option Chain for Boise showing Strikes reduced by $0.72 for dividend.