For those who expect a move up or down in the SPX index over a given timeframe, buying an SPX straddle might be an appropriate strategy to consider. If expectations of an SPX move come true, an investor is positioned to profit on either the upside by owning a call or the downside by owning a put at the same time.
At expiration, the profit potential on the upside from the long call is theoretically unlimited. On the downside the profit potential from the long put is substantial, limited only by the SPX declining to no less than zero. The maximum loss for the long straddle is limited to the total premium paid for the call and put, and will generally occur at expiration with the SPX closing at the straddle’s strike price and both at-the-money options expiring at-the-money and with no value.
Time decay has an especially negative effect on a long straddle because this decay is simultaneously working against the straddle owner on two long options, a call and a put. The straddle owner is also especially vulnerable to changing volatility while holding the straddle. A decrease in volatility has a simultaneous negative effect on both the long call and long put. On the other hand, an increase in volatility will have a positive effect on the market prices of both the call and the put, which can possibly overcome the natural time decay in their values and result in a profit without a move in the SPX index. This might be another motivation for purchasing the straddle in the first place.
Selling vs. Exercising Expiring SPX Options
Remember that SPX options have European-style exercise and A.M settlement characteristics. An investor with a long call or put position may sell that position, if it has market value, on any day up to and including the business day (usually a Thursday) preceding the day on which the exercise settlement value is calculated. However, the option contract(s) may be exercised only on the day the SPX exercise settlement value is calculated and disseminated, or the last business day (usually a Friday) before the expiration date.
In other words, an investor with an expiring long SPX call may observe current market prices during its last trading day (Thursday) and have the opportunity to sell it before the market closes. If on that day the investor considers exercising the call instead, he will be exposed to a degree of overnight market risk. This is because the cash settlement amount received upon exercise will not be known until the following morning (Friday) when the market opens (possibly up or down significantly) and the exercise settlement value is calculated. As well, an option that is in-the-money (or out-of-the-money) at the close of the last trading day may or may not be so the next morning when compared to the calculated settlement value.
Option Premium and Exercise Style
Investors may observe that European-style options trade at lower relative value than American-style options with similar contract size. This is because investors may pay more for American-style contracts in exchange for the right of early exercise (before expiration). And because European-style options may be exercised only on a given day before expiration, during their lifetime some in-the-money contracts (notably puts) may commonly be priced and trade below parity, or below their intrinsic value.