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Straddle

Description

        The Straddle is the most popular volatility strategy and the easiest to understand.
           We simply buy puts and calls with the same strike price and expiration date so that
           we can profit from a stock soaring up or plummeting down. Each leg of the trade
           has limited downside (i.e., the call or put premium) but uncapped upside.
           Assuming that the movement of the stock is enough to cover the cost of the trade,
           we should be profitable.

             However, we also need to apply various rules when trading straddles. The prob-
           lem with buying options includes time decay and the Bid/Ask Spread. Time decay
           hurts long options positions because options are like wasting assets. The closer we
           get to expiration, the less time value there is in the option. Time decay accelerates
           exponentially during the last month before expiration, so we don’t want to hold
           onto OTM or ATM options into the last month. We also do not want to be buying
           and selling the same Straddle too frequently because typically the Bid/Ask Spread
           is quite wide, and if we continually buy at the Ask and sell at the Bid when the stock
           hasn’t moved for us, then the spread will cause us to lose.
              So we must have a number of reasons for getting in, staying in, and then getting
           out. We also need to know that the price that we are paying for the Straddle is rea-
           sonable in comparison to the propensity the stock has to making a significant move.
           In other words, the cheaper the cost of the Straddle, the better, provided that the
           stock is one that can and will move explosively.
              Here are the rules for trading straddles:
     
           1. Its better to choose stocks over $20.00, preferably no more
              than $60.00. Thats not to say that you cant make profits from stocks outside
              of that range.
     
           2. Only do a Straddle on a stock that is close to making an announcement, such
              as the week before an earnings report.
     
           3. Buy ATM calls and puts with the expiration at least two months away, preferably
              three. You can get away with four months if nothing else is available.
     
           4. The cost of the Straddle should be less than half of the stock’s recent high less
              its recent low. By recent, we mean the last 40 trading days for a two-month
              straddle, the last 60 trading days for a three-month straddle, or the last 80 days
              for a four-month straddle. The point here is that the cost of the Straddle should
              be low in comparison with the potential of the stock to move.
     
           5. Exit within two weeks after the news event occurs. Try to avoid holding the
              position during the final month before expiration. In the final month, options
              suffer from accelerating time decay, which would therefore erode our position.
     
           6. Try to find a stock that is forming a consolidation pattern, such as a flag or
              pennant, or in other words, where the stock price action has become tighter and
              where volatility has shrunk in advance of a big move in either direction. You
              should familiarize yourself with the basics of technical analysis at the very least.


           Its important to follow the entry and exit rules for straddles, and psychologically
           speaking, the Straddle is a tough strategy to play after you’re in. It’s very easy to
           find reasons to exit, even though it’s in breach of your trading plan. But you must
           remember that you got in for a certain reason (or reasons), and you must stay in
           until one of your other reasons compels you to exit.

P/L Profile

    
    
    
     Steps to Trading a Straddle
     
         1.    Buy ATM strike puts, preferably with about three months to expiration.
     
         2.    Buy ATM strike calls with the same expiration.

           Steps In
     
             Actively seek chart patterns that appear like pennant formations, signifying
              a consolidating price pattern.
     
             Try to concentrate on stocks with news events and earnings reports about
              to happen within two weeks.
     
             Choose a stock price range you feel comfortable with. For some traders,
              thats between $20.00 and $60.00.
     
           Steps Out
     
             Manage your position according to the rules defined in your Trading Plan.
     
             Exit either a few days after the news event occurs where there is no move-
              ment, or after the news event where there has been profitable movement.
     
             If the stock thrusts up, sell the call (making a profit for the entire position)
              and wait for a retracement to profit from the put.
     
             If the stock thrusts down, sell the put (making a profit for the entire posi-
              tion) and wait for a retracement to profit from the call.
     
             Try to avoid holding into the last month; otherwise, you’ll be exposed to
              serious time decay.


       Net Position
     
            This is a net debit transaction because you have bought calls and puts.
     
            Your maximum risk on the trade itself is limited to the net debit of the bought
             calls and puts. Your maximum reward is potentially unlimited.


     
       Effect of Time Decay
     
             Time decay is harmful to the Straddle. Never keep a Straddle into the
              last month to expiration because this is when time decay accelerates the
              fastest.
     
     
       Appropriate Time Period to Trade
     
             We want to combine safety with prudence on cost. Therefore the optimum time
              period to trade straddles is with three months until expiration, but if the stock
              has not moved decisively, sell your position when there is one month to expira-
              tion. Be wary of holding a Straddle into the last month.
     
     
       Selecting the Stock
     
             Choose from stocks with adequate liquidity, preferably over 500,000 Average
              Daily Volume (ADV).
     
             Actively seek chart patterns that appear like pennant formations, signifying a
              consolidating price pattern that may be about to explode.
     
             Try to concentrate on stocks with news events and earnings reports about to
              happen within two weeks.
     
             Choose a stock price range you feel comfortable with.
     
     
       Selecting the Options
     
             Choose options with adequate liquidity; open interest should be at least 100,
              preferably 500.
     
             Strike - ATM for the put and call.
     
             Expiration - Preferably around three months. Use the same expiration date for
              both legs.

     Advantages and Disadvantages
     
     Advantages
     
          Profit from a volatile stock moving in either direction.
     
          Capped risk.
     
          Uncapped profit potential if the stock moves.
     
     Disadvantages
     
          Expensive. you have to buy the ATM call and put.
     
          Significant movement of the stock and option prices is required to make a
           profit.
     
          Bid/Ask Spread can adversely affect the quality of the trade.



     Exiting the Trade
     
       Exiting the Position
     
             With this strategy, you can simply unravel the spread by selling your calls and
              puts.
     
             You can also exit only your profitable leg of the trade and hope that the stock
              retraces to favor the unprofitable side later on. For example, if the share has
              moved decisively upwards, thus making the call profitable, you will sell the
              calls and make a profit on the entire trade, but you will be left with almost
              valueless puts. Having now sold the calls, you will hope that the stock may
              retrace and enhance the value of the puts you are still holding, which you can
              then sell.
     
       Mitigating a Loss
     
             Sell the position if you have only one month left to expiration. Do not hold on,
              hoping for the best, because you risk losing your entire stake.
     
     
Example

           ABCD is trading at $25.37 on May 17, 2004.
     
           Buy the August 2004 25 strike put for $1.70.
     
           Buy the August 2004 25 strike call for $2.40.


     Net Debit      Premiums bought
                    $1.70 + $2.40     = $4.10        
                                   

     MaximumRisk    Net debit       $4.10          
                                   

     MaximumReward  Uncapped       
                                   

     BreakevenDown  Strike - net debit   = $25.00 - $4.10  =  $20.90            
                                   

     BreakevenUp       Strike + net debit = $25.00 + $4.10 =  $29.10
                                 

                                   
                                   
           So we can see that if we held on to expiration, our breakevens would be $20.90 and
           $29.10, respectively. In other words, the stock would have to fall to below $20.90 or
           rise above $29.10 in order for us to make a profit. In reality we don’t hold on until
           expiration, and therefore, because both options will still contain some time value
           before that final month, our breakevens will be slightly more narrow, which of
           course helps us.
              In the previous example, we havent taken into account the rules, but let’s assume
           that there was an earnings announcement on, say, May 21. Let’s also assume that the
           three-month high had been $26.49 and the three-month low had been $16.39. The         
           difference between the two is $10.10. Divide in half to get $5.05, which is greater than
           our Straddle cost of $4.10. Therefore we passed the rules, assuming of course that the
           chart pattern was acceptable!


	



 
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