Our first (July 2016) straddle was a losing trade, thanks to Brexit.  We opened the trade on 10 June with 41 DTE when XJO was trading around 5300. XVI was at 15.9 giving us an IV Rank of 20%. We collected premium of 218 points for an ATM Jul’16 5300 short straddle giving us breakeven points at 5082 and 5518. XJO fell heavily immediately after we opened our trade due to Brexit fears but reversed soon after. The day before Brexit, XJO was trading right around 5300 which is the sweet spot for our short straddle. In normal circumstances, our trade should have been in profit from the 13 days of time decay but our trade was showing a small unrealised loss as IV had risen due to Brexit uncertainty.

XJO as at 29 June 2016

Brexit Friday (24 June) was a scary day – XVI spiked to a high of 26 when the market fell 3% that day. The pricing for XJO ITM put options went completely crazy! I saw bid ask spreads of 100 points and sometimes there were no quotes available. I forgot take a screen shot of the option chains that day but as you can see from the screen shot below taken on 28 June, there were no quotes for many deep ITM put options. The bid/ask spread for the 5400 put option was 52 points (bid at 334 and ask at 386)!

Option chain 28June16

It was really hard to know what the value of our position was so I decided to close our trade when I could do so at a price that was slightly above our loss threshold. The lack of quotes for ITM options had happened once before when we were trading iron butterflies. I did a little research on market maker (MM) obligations for ASX exchange traded options and was really surprised to find out that  MMs are only obligated to provide continuous quotes for 8 puts and 8 calls for the top 20 Exchange Traded Options 50% of the time (see ASX paper) . There are no requirements for the quotes to be for ITM or OTM options which explain why there were no prices for a lot of the ITM options.

If there are no continuous quotes for an option, we can always request for a quote from the MM. According to the same paper, there is a maximum bid/ask spread for MM quotes as shown in the table below.  As you can see, the spread increases with the price of the options.

Schedule 6

Based on our experience this month as well as what we now know about XJO option pricing, I am reluctant to continue to trade short straddles on XJO for the following reasons:

  • Without continuous quotes on ITM options, it is very hard to monitor our trade as we cannot get up-to-date valuation of our position when we need it most
  • We would normally reach our loss thresholds when one of our option trades above 250 points. With a 35 point spread, it would be very expensive if we have to pay the full ask price to the MM to close our trade.

With volatility set to remain high (with Brexit and potentially more EU exits, Australian and US elections etc), conditions are favourable for short straddle trades. They are most profitable when IV is high and there are other good points about the straddle strategy such as high system quality and relatively stable margin requirements. It would be a real shame not to be able to trade them but it is far too risky to trade undefined risk trades with illiquid options.

Due to the lack of liquidity of XJO options, it would be better if we can predefine our risk so that our maximum risk is no more than 25% of premium collected. This way we do not need to worry about having to close trades at bad prices in extreme market conditions. This is the approach I take when I sell calls or puts on ASX stocks with illiquid options. When I sell an option, I have to be prepared to hold to expiry as I normally cannot buy it back at a good price. In volatile markets we often find big drops are followed by equally big rallies (just like what we have seen with the whole Brexit episode). Hence it would be good if we do not have to close trades when they breach a loss threshold just to see the loss reversed a few days later!

I found that I could limit max loss to roughly 25% with 3% wide iron butterflies as shown in the example using SPY below. This is a pretty narrow iron butterfly but if we manage our trade early, our profit zone (as shown by purple line) can be wider than what they would be at expiry (as shown by the green line).

IB with 25 percent max risk


I will try this out with XJO and perhaps start a XJO Iron Butterfly (Mark II) model portfolio to replace our XJO Straddle model portfolio.

Disclaimer: This post is for educational purposes only and should not be treated as investment advice. This strategy would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek investment advice if required.

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