Where are interest likely to go?

Equity market vacillates depending on which direction the interest rates winds are blowing. Up 100+ points one day, down 100+ points the next. A trader’s dream, a buy and hold nightmare.

What we know, is that a discernable lack of clarity exists on the real direction of interest rates. Which if played properly can spell opportunity for straddle buyers. Especially if option premiums have not fully discounted the interest rate question.

To find an answer to that question, please turn your attention to the MX Implied Volatility Index.The MX Implied Volatility Index measures the volatility being implied by near-term at-the-money options on the S&P/TSX 60 iShares.

It can be used to gauge the general level of option premiums at a point in time. A high value on the MX Implied Volatility Index indicates that premiums are higher than normal, a low reading indicates “cheap” option premium. Cheap being a relative term.

At present, the MX Implied Volatility Index is trading at 14.45%, which has come down from a high above 16%, and is just slightly above XIU’s 30-day historical volatility. In short, I don’t think option traders are fully discounting the uncertainty around interest rates.

Having said that, it is not enough to simply buy a straddle because you think the price is cheap. If you buy a straddle, and the underlying moves up sharply one day and down the next, you could spend the next month watching time value erode the low cost straddle into oblivion.

To make a straddle work, you need to do one of two things; 1) you need to believe that the underlying security (XIU in this case) will move dramatically one way or the other before the option expires; or 2) if you believe the underlying security is likely to spend the next few weeks trapped in a widening trading range, you need to lift one side of the trade and hold the other for a pull back or bounce.

In other words, this trade has speculative underpinnings and should only be contemplated with money you can afford to lose.

With all of the caveats in place, you might look at the XIU July 80 straddle at a net debit (before transaction costs) of $3.00.

If you believe the trading range environment is the most likely scenario, be prepared to move quickly with limit orders on both sides of the trade. In other words, enter the position and set limit prices to exit one side or the other depending on where the market goes.

Typically traders set limits 50% above or below the entry point. So if you pay $1.50 to buy the XIU July 80 calls, you would set a limit price to sell at $2.25 the XIU July 80 calls. Similarly, if you pay $1.50 for the XIU July 80 put, set a limit sell at $2.25.