The post below is from Eric at The Stock Market Prognosticator. Free free to leave a comment or let him know if you have any other option tips you would like him to write about.
It is important for investors not panic during the current market volatility. Money can be made on both the upside and downside. One of the strategies I employed recently involves using options to take advantage of this volatility. During the month of July, I opened "straddle" positions on six different stocks and ETF's. I closed all of them out at a profit within two weeks.
So here is how it works, a straddle is the simultaneous purchase of an equal number of both calls and puts on the same underling stock, ETF, or index. Both the calls and the puts should have the same strike price and same expiration.
What I am looking for is a large move by the stock before the options expires. I am indifferent as to which way the market moves, as long as the combined premium when I close it out is more than the combined premium that I paid.
Here are some other things to know:
1) Make sure that the options have several weeks to expiration so there is time for the underlying instrument to move.
2) Pick only options with large volume and narrow spreads, a few pennies per contract is best.
3) Be careful about using this strategy when the underlying instrument has very high-implied volatility, as all other things being equal, a high implied volatility leads to a higher option premium. If this implied volatility suddenly dissipates then one side of your position may drop sharply in price.
4) I usually wait until the underlying instrument is trading right at the strike price, so the options cast per contract is roughly the same.
Here is an example of one of my trades:
I purchased the Financial Select Sector SPDR (XLF) July 21 Calls and July 21 Puts at a price per contract of $1.14 and $1.13 respectively. This position was opened prior to the huge rally in financials last week. Four days later I closed the position out, selling the calls at $2.28 and the puts at $0.51 per contract. The profit before commissions per contract was $0.53, or $53.00. So a round lot of 100 contracts would have yielded a profit of $5,273 in less than a week.
Investing in options carries a lot of risk, so please decide yourself whether a strategy like this is correct for you as an investor.
If you would like to learn more about my investment philosophy, then please visit The Stock Market Prognosticator.
15 thoughts on “Straddling Options”
Mark Brant...I decided to check in on our test trade that we did back in July. The trade was:
"XLF Dec 08 15 puts are $0.36-0.40 and the XLF Dec 08 27 Calls are $0.47-0.50. The XLF is at $21.61."
Today the XLF Dec 15 puts are $0.79-0.83, and the XLF Dec 27 Calls are $0.11-$0.16.
Closing the trade now would net $0.90 vs. a cost of $0.90. Still three months to go.
Trading System Creator...sorry to take so long but I lost track of this thread. You asked "do you think the implied volatility measures or factors in whether the consensus is concentrated or not?"
I honestly don't know the answer. Usually if there is an outlier on an earnings estimate, some people assume it is stale and just ignore it. In fact I have seen companies, say that they beat earnings consensus if you ex out an outlier on an estimate from an analyst.
Nice, thanks. I have a question but first...
Roman made a comment regarding the purchasing of straddles before an earnings announcement.
I'd like to add a tip.
An earnings announcement (or any other data announcement) has a consensus prediction. For example, the prediction might be earnings of $1 just as an example. This is the steets expectations.
But a streets expectations can be 'concentrated', or it can be an average of a very varied and wide broad consensus.
For example, the $1 estimate, in a concentrated consensus, 90% might have the estimate at around $1, the other 10% give or take a few cents.
A varied and broad estimate might have anything from 50 cents to $1.50 and no one number has any more weight than any other number, BUT when you average them out, you get $1, which is the streets expectation.
So, if an earnings estimate is concetrated, and the announcement is even slightly off, expect some volatility, but if the estimate is varied, even an announcement that seems well off the street average estimate, wont create much volatility, in fact there wouldn't be much voltility unless the announcement was outside the broad range, in this case lower than 50c or higher than $1.50
So the question is, do you think the implied volatility measures or factors in whether the consensus is concentrated or not?
Mark...let's do a test trade on that. Right now the XLF Dec 08 15 puts are $0.36-0.40 and the XLF Dec 08 27 Calls are $0.47-0.50. The XLF is at $21.61.
THE BEST WAY TO BE LONG BOTH SIDE OF VOLATILITY IN STOCK OPTIONS IS TO BUY DEEP OUT OF THE MONEY STRANGLES WITH EXPIRATION 2-6 MONTHS OUT. PREMIUM IS ALWAYS CHEAP AND PAYOFFS ARE NONLINEAR. NICK TALEB DESCRIBES SUCH STRATEGIES IN "FOOLED BY RANDOMNESS."
Sometimes stocks that are very volatile may not be suitable for this strategy. For example, Freddie Mac and Fannie Mae have been on a roller coaster the last month or two. I checked the options and found that they trade with spreads of 10 to 15 cents at times. This is on a base price for the option in the $2-3 range. So a typical quote would be $2.10- $2.20. This is too wide for me so I didn't play them. I try to find an option with a 1 or 2 cent spread.
Syl...there are complex formulas to measure volatility but for me I observe the underlying instrument and the options to see how they trade. I just get a "feel" for it.
Steve...I have used this strategy on the QQQQ and the SPY. SKF has options but I believe they are very illiquid. The others I haven't traded.
(Investing in options carries a lot of risk, so please decide yourself whether a strategy like this is correct for you as an investor. I am not making a recommendation for everyone since I do not know your financial situation and/or risk tolerance.)
Pete and Forex Shark...I don't use limit orders because I use the GS Redi plus trading system which executes the orders almost instantly. I would advise others to use limit orders as you stated.
Roman...interesting what happened to you on AAPL. I had the exact opposite experience for GE. The day after earnings came out, the puts I was long dropped 50%. Everyone was hedging positions of GE stock and the report turned out to be not so bad. The calls didn't move up enough to cover the put loss but later that week I closed out at a profit.
Manzoor54...I used the 100 lot as an example only. I prefer to keep my actual position confidential.
This stragedy may be good for big players as u guys can see , in this example he bought 100 lots , this meant underlying 10,000 shares exposure .
I would prefer to write gold out of money put or call option and i will wait till it reach one extreme as in todays case gold came down more than 85$ an ounce in 6 working days, so it was wonderfull opportunity to write way out of money puts, such as sep 860 , which i receved 760$ per contract,and i sold 5 lots beside soem expensive ones such as sep 890 put @ 1490 per contact. this way at least I am reving money rather than dishing out and wondering if i will mak or loose most of upfront paid premium. thx and have successful tarding.
IS STRADDLES GOOD TO USE ON THE FOLLOWING STOCKS: GOOGLE/SKF/QQQQ/SPY/BIDU??? ANY OTHERS TOCKS YOUCOULD GIDE ME TO FOR A STRADDLE ALSO WHAT MONTH OUT AND AT THE MONEY IN THE MONEY OR OUT OF MONEY OPTIONS???
Yes, and how about GOOGle - last earnings report it dropped $50 I should have used a straddle on that one 🙁
Straddle, great strategy to trade volatile options of equities before earnings reports..just make sure you know the exact date of earnings report (BMO/AMC)and the conference call..also dont forget to analyze the past behaviour just after the earnings were released. Last time, when releasing AAPL earnings you could make 50 % after the earnings!
is basically an Forex Trading Strategy to trade Forex when you don’t know which way the currency PAIR will head, but you know it will move,big magnitude in one direction. And thus, you place TWO LIMIT ORDERS.
Do you use limits when placing orders?
You mention " Be careful about using this strategy when the underlying instrument has very high-implied volatility, as all other things being equal, a high implied volatility leads to a higher option premium."
What is "high" implied volatilty?? 35%, 40%, 50%
How would one know what is considered high??
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