Last month, I highlighted a symmetrical triangle pattern in the iShares Silver Trust (NYSE:SLV) and suggested a big breakout was looming for the precious metal. One of the recommended plays to exploit the return of volatility was purchasing the May 28 straddle for $1.84. Fast-forward to today, and with SLV plummeting about 9% and its implied volatility skyrocketing, the straddle has racked up a roughly 50% gain.
While greed might be tempting us to sit tight and let additional profits accumulate, the prudent course dictates making a change to reduce our overall risk. Before I discuss the strategic adjustment, let’s review the dynamics of a long straddle trade.
Click to Enlarge The long straddle is entered by purchasing an at-the-money call option and an at-the-money put option. It offers limited risk and unlimited reward, and is considered a bi-directional, long-volatility strategy — which is to say, you make money off of either a large increase or decrease in the stock price or an increase in implied volatility. Fortunately for the May 28 straddle, we’ve seen both changes occur. Since May 21, when the trade was originally recommended, SLV has fallen from $28 to $25.50 — a 9% decline.
Notice how the previously contracted Bollinger Bands have now expanded considerably. Last time we discussed SLV, the width between the bands was a mere $2.95, showing extreme compression in silver’s volatility. With the recent breakdown, the Bollinger Band width has risen to $11.51 (bottom panel in accompanying chart).
At the same time, implied volatility, as measured by the CBOE Silver Volatility Index (CBOE:VXSLV), has climbed from 23 to over 30 — a 30% surge. Since IV is driven by supply and demand for options, the 30% rally reveals that demand for SLV options has risen considerably, especially during Friday’s precipitous downdraft.
Click to Enlarge The problem with large spikes in implied volatility is that they typically don’t last very long, quickly reverting back to the mean.
Which brings us to the strategic adjustment for the May 28 straddle. One way we can exploit the sudden increase in option premiums and reduce the overall risk of the position is by selling an out-of-the-money put option such as the May 24.50 put for 45 cents.
The 45-cent credit reduces the overall risk from $1.84 to $1.39. It also reduces the directional and volatility risk by adding positive delta and negative vega to the position. If SLV rebounds in the coming days, the gain from the short 24.50 put will help offset the profits that are given back on the existing straddle. And if implied volatility drops back down, we will make money on the short 24.50 put, which will help partially offset the profits we give back on the existing straddle.
Click to Enlarge The primary trade-off for selling the May 24.50 put is that our potential profit on the downside is now capped at $2.10 instead of being unlimited. But hey, a $2.10 profit is still over a 100% return on the initial trade cost, so it’s still quite substantial.
The net effect of the adjustment is perhaps best viewed using risk graphs. The position pre- and post-adjustment is shown to the right:
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.