As a stock trader have you ever wished there was a way for you to bet on a huge in either direction?Then he thought about the option strategy Optionz Traderz had used in the past.
Their is an option strategy that allows you to do just that; they are called long Strangles and Straddles.
It is possible to have a winning trade even when you have don’t know which way the next price move will move. How is this even possible?
You bet on a trade both ways.
So are not specifically bullish or bearish you are just beating on a strong move in one direction or the other.
When you want to enter into a trade that anticipates that news or earnings announcements will create a sharper move in a market or stock than is priced into the options then the option strangle or straddle option play could be the right one for you. You create a long option strangle trade by buying both and out-of-the-money call and an out-of-the-money put the same distance from the current market price and at the same expiration. A long option straddle play is created by buying both an at-the-money call option and an at-the-money put option. For these option trades to be profitable the anticipated volatility priced in through the Vega value must be low enough so the trade can be profitable after this premium is priced out after the event. The bigger than anticipated move can trend strongly in either direction for this option trade to be profitble. It does not matter which way the move occurs it just requires a move of a strong enough magnitude to bring one side of your option strangle or straddle close enough to being in-the-money to pay for the opposite side of the trade and leave money over for profits after commission and slippage. One great thing about option contracts is that they are able to capture the upside of a move and at the same time limit the downside move to no more than the option contract itself. After the catalyst of an event has passed for your long strangle or straddle to be profitable the winning side has to be worth enough to offset the loss of the losing side. The odds are that the losing side of strangle will be zero, so profitability is all based on the winning side.
You can profit from different option plays their are different strategies that can be used based on the current market behavior, volatility, and trend. A long option strangle or straddle is a bet on an big move in either direction. This strategy allows you to bet on a big move or trend, not a direction, just that there will be a move of a strong magnitude. They are not as complicated as they may sound.
They are not really as complicated as they sound. Long strangles are opened when you buy both a Put and a Call out-of-the-money on the same equity, the same distance from the current price, with the same expiration date. If you wanted to put a long option strangle on Apple stock at $100 because your thought is was at a crossroads at the 200 day simple moving average and could breakout and trend strongly in either direction over the next month then you could proceed to buy a $105 strike front month call option and a $95 front money put option. If they were both $100 to open with one contract then the play would cost you $200 if price trended to the strike price of either of the options by expiration and went in the money by more than $2 then the strangle would be profitable. If Apple moved to $107 or $93 it would be break even but if price went higher or lower than those price it would be profitable. At an Apple stock price of $109 or $91 then the return on the capital at risk would be 100% as the winning side of the strangle would be worth $400 in intrinsic value by expiration. The quicker a Strangle goes in-the-money the better as more time value will be in the options on both sides.
Long Straddles are opened when you buy both a Call and a Put on the same stock, for the same expiration date and both are at-the-money. Strangles require more capital than Strangles to open; but you need a stronger move to bring one of them deep enough in-the-money, before expiration, to make enough profit to offset the total cost of the trade. If Apple is trading at $100 then you would buy an $100 strike call option and a $100 strike put option front month for $500 each or $1,000 in total cost. Your straddle would break even at expiration if Apple was at $110 or $90 as the intrinsic value would be worth the original cost. You are profitable if Apple goes over $110 or under $90 at expiration. It would take a move to $120 or $80 to double your value of capital at risk. The benefit of a straddle over a strangle would be that if a big move happens early in the trade the losing side could still have remaining theta or Vega value to help offset the original cost. A straddle captures all the intrinsic value of a move in the underlying stock. Some option traders simply sell the losing side early if a trend emerges and let their winning side run.
A Strangle or straddle can expire 100% worthless if held to expiration if neither side makes it to being in-the-money. It can also have a huge percent return on the capital at risk, by one side going very deep in-the-money. In almost all cases it requires one side of the trade to go in-the-money and be worth enough in intrinsic value to offset the cost of the Theta and Vega from the entry point.
The Straddle captures the full move of the equity in-the-money. One of the options will be in-the-money almost instantly, and will always be worth the amount of the move in intrinsic value. Also the odds are, after a strong move, the losing side will still be worth something. However, although the Straddle requires more capital, it requires a smaller move than an option Strangle to make enough on the winner to pay for the loser as the losing side maintains some value unlike in a strangle.
You can structure this type of option trade based on what you think will be the magnitude of the move either way. If it is a macro event you can choose which stock or sector will move the most; the one you think will be most under anticipated to be impacted. If Priceline has earnings you could strangle Expedia, if Facebook has earnings you could Strangle Twitter. Interest rate announcement may lead you to strangle the financial sector ETF. Strangles and straddles can allow you to capture a big move without predicting the direction. After a move takes one side of your option play in-the-money you will then capture the complete upside from that point in intrinsic value. Strangles and Straddles are non-directional bets on Gamma scalping. These option plays are profitable based on the expansion in Delta and the ability to have a very large percentage return on one side of the trade.
Strangles and Straddles option plays are designed to capture one direction of a potential outsized move, inside a defined period of time, for the expense of two option premiums. These are asymmetric bets that have limited downside of the contract costs but unlimited upside with intrinsic value in a trend. Long Strangle and Straddle option plays have built-in stop losses that limit the loss to the cost of the contracts. You pay a put option seller to allow you to bet on a downtrend, and you a pay a call option sellers to sell you a bet on an uptrend. The profits from a long Strangle or Straddle profits come from the fact that you did not pay one side of the option sellers enough money to bet on one of the trends. Both the option sellers you bought from exposed themselves to the risk of an outsized trend occurring that would be greater than what they charged you in option premium. Your profits in this trade come from the under estimation of the risk the option seller had on one side of your play. Profits in these strategies come from bigger than expected moves in the market.
A Strangle or a Straddle can be exited at anytime during the life of the trade. It can be exited for only a loss of time value early in the trade if the expected move did not happen. It can be exited early if the move happens and it is very profitable to take the money off the table early. It can be wise if it is a catalyst based trade to exit after the catalyst has passed if it is a winner or a loser. Other times if your plan is a trend trade then you allow your winning side to run as it goes in-the-money.
When Strangles are used to trade through company earnings reports it requires a move in the stock greater than anticipated for profitability. Unexpected earnings results can drive a stock price greater than the velocity expected when afterhours traders panic and buy or sell driving the price wildly. Stock traders emotions can cause a stock to move far higher or lower than was anticipated by earnings estimates and price targets. Even though options do not trade after hours it is possible to hedge the winning side of your Strangle by buying or selling the same amount of stock that you have options on. If you want to lock in the profits on your put option side you simple buy an equal amount of stock in the after hours to hedge your put options. Your put options can’t be any more profitable but the long stock will offset any move against your put contracts. The time to put on a Strangle or Straddle is when options are not pricing in a potential trend that could be bigger than is anticipated.
There is the chance that price does not move enough to make your Strangle or Straddle profitable before expiration. Also the Vega value based on anticipated volatility is priced out after the event leaving you with a loss. Price can also move just far enough for you to break even before commission costs and slippage. Strangles and Straddles can expire completely worthless if held all the way to expiration,
Trend Trader: How can you help manage these risks?
Optionz Traderz: When you are wrong, the best thing to do is just get out early and go look for a new play. Never hold until expiration unless you are just so deep out-of-the-money that the liquidity has dried up in that contract, and you would lose too much in the bid/ask spread to justify selling it. Also sometimes a bigger move than you expect may be priced-in and the options are just too expensive to be able to profit. This has happened to me many times. When I buy Straddles, I am looking for the under-estimation of the seriousness of an event to move the market.
(Stock Trader did not want to appear as if he was rude; but his curiosity was increasing. The Dow had soared more than 400 points in one day; a move that could have given him thousands of dollars in profits. But his trend trading system did not work efficiently in volatile whipsawing markets, so he was on the sidelines, waiting for the market to settle down. Meanwhile, Optionz seemed almost as if he welcomed the recent volatility. It was time to get some answers.)
Stock Trader: Sorry to interrupt. You are a good teacher. Did you pull off another Long Strangle money heist?
Optionz Traderz: Yes, I started building a position when all the drama began in Europe; I bought when the options were more affordable, when volatility was lower. As volatility grew and the down trend deepened, my options also grew in value, with both increasing Vega and my Put side going in-the-money. I closed out my first play then opened up a new one, and lost with the market being range bound. My latest short term play on the EU bailout announcement worked well, with the 400 point pop in one day.
Stock Trader: So what is your system Strangle/Straddle win rate?
Optionz Traderz: Only about 50%.
Stock Trader: Big wins, little losses?
Optionz Traderz: Exactly; my wins pay for my losses and leave me a profit.
Trend Trader: So to win in an option Strangle or Straddle I have to be right about the timing of the trend, and the velocity?
Optionz Traderz: Yes, they are only for times of massive uncertainty, with outcomes that have the potential to move violently one way or the other. You have to overcome the priced-in volatility of the options to win. When you buy Straddles or Strangles, you are betting that volatility will change; either Implied Volatility will increase significantly and stocks will sell off; or Implied Volatility will fall significantly and stocks will surge.
Trend Trader: What about exits?
Optionz Traderz: Just like in trend trading, you might want to exit on a stop when the trend reverses; or you might have a time exit, where you exit after the event catalyst has passed and you presume that the move has already happened.
Stock Trader: What is true in stocks is also true in options. The only difference is just a few more moving parts.
Trend Trader: I need to look at some option chains and really get the feel for how this works; I think I have the basics now.
Optionz Traderz: Good for you; glad I could help.
Stock Trader: So how do you decide when to use a Straddle and when to use a Strangle?
Optionz Traderz: Often, the outcome of both strategies is similar, especially on more volatile stocks. If you consider an at-the-money Straddle on a stock, Delta on both of the options will likely be close to 0.5. That means that lowering the strike price of the Put by $1 should save you about 50 cents in premiums, while increasing the strike of the Call by $1 would do the same. All together you would save $1 in premiums, but be entitled to $1 less of any trend that developed. In a case like that, I would choose the Strangle over the Straddle, because I would have the same potential profit with much less capital at risk.
Stock Trader: That is interesting. The Strangle would cause me to miss out on the first $1 of the move in the stock price, but would save me $1 in premiums compared to the Straddle.
Optionz Traderz: Exactly, so why put yourself at risk of losing the additional premium, if no move ever occurred. You would lose a lot more money on the Straddle, but have nearly the same profit potential as a Strangle.
Stock Trader: So if I went out $2 in price on the strike of both options, wouldn’t I save $2 in premiums and then miss the first $2 of any change in the stock price?
Optionz Traderz: Not necessarily. That may be true on very volatile stocks, but those with lower volatility have Deltas that drop off considerably with strike prices that are out-of-the-money. So it is possible that moving out both options by $2 might only save you $1.50 or so in premiums. On stocks with very low implied volatility, you might save even less. But you are correct, when you are talking about Strangles on highly volatile stock.
Just as an example, Trend Trader had asked me about a Strangle on the DIA ETF. With the shares currently trading around $116, a Strangle consisting of a $114 Put and $118 Call with November expiration would have a combined premium of $4.31 and would pick up any movement of the share price in excess of $2.00. Meanwhile, a straddle consisting of a Call and Put, both at the $116 strike would cost $6.17 and pick up every penny of movement in either direction. However, the straddle costs $1.86 more to open; you really aren’t getting much added benefit from a Straddle versus a Strangle, but you are taking on a lot of additional risk.
Stock Trader: So a Strangle would be better on volatile stocks; what about less volatile ones?
Optionz Traderz: That’s a choice you need to make based on what your indicators are telling you about the market, and how confident you are about that information. Straddles are very expensive, so it takes a big move to offset their cost. Strangles are less expensive, but it actually takes a bigger move in the underlying price to generate a profit than would be necessary with a Straddle.
Stock Trader: That seems strange. I would have thought a Strangle would perform better because of the lower initial outlay.
Optionz Traderz: If you consider that the premium on an at-the-money option is equal to approximately 40% of one standard deviation of the underlying stock price, based on the amount of time to expiration, then a Straddle will generally cost you about 80% of one standard deviation. So the stock price would need to move 80% of a standard deviation just to get to the break even point. That might seem like a lot, but stocks generally only stay within such a tight range around half of the time.
If you compare that to a Strangle, with strikes that are out-of-the money by half of a standard deviation, they will usually cost about half as much as those required for the Straddle. Because they cost half as much, their combined premiums are about 40% of one standard deviation. So the underlying price needs to move 50% of a standard deviation just to get to the strike price, then another 40% of a standard deviation to get to the break even point, which would likely be near 90% of one standard deviation; slightly more than is required for a Straddle.
Stock Trader: So if I was confident that my technical analysis was pointing to a strong trend, a Straddle would be a better choice, because it would have a better payout. But, if I was less sure of a trend, I could cut my risk in half if I chose a Strangle with strikes about half a standard deviation out-of-the money.
Optionz Traderz: That is true. The profit from the Strangle would be slightly lower, but with about half as much capital at risk. As always, you need to make sure the options have enough liquidity at the strikes you are choosing. Strangles are much more vulnerable to liquidity issues than Straddles, because out-of-the money options almost always have larger bid/ask spreads; and you are exposed to that risk on both legs of the trade.
Stock Trader: Good point; anything else to consider?
Optionz Traderz: Well, you don’t need to confine yourself to buying Straddles or Strangles; you can also sell them.
Stock Trader: That seems riskier than the Naked Puts we were talking about.
Optionz Traderz: Yes, they do have risks, but like every option strategy, the key is managing that risk.
Stock Trader: So how would I manage the risk on a short Straddle or Strangle?
Optionz Traderz: The first thing to do is to make sure you are selling them at the right time, to give yourself better odds. When the markets are losing value and volatility is rising quickly, Straddles and Strangles can be very risky. Not only would you be risking a big loss on the put side if the downtrend worsened, but Implied Volatility would probably rise too, and that would likely increase your loss. Short Straddles and Strangles both have a slightly bullish bias; many times they perform better when prices are rising, due to Vega causing them to lose some of their time value.
Stock Trader: So when prices are starting to recover, but volatility is still high, would that be a good time? I’d still be getting some good premiums, but if the uptrend continued and volatility declined, I’d be able to cut any losses on the Call side of the trade and take profits on the Put side, because volatility would be working in my favor on both.
Optionz Traderz: Exactly. Bear markets, with increasing volatility, are usually more dangerous for Short Straddles and Strangles than bull markets. So, once you have picked a good time to open the trade, the next thing to do is to choose the right strike price. You might be tempted to sell a Strangle instead of a Straddle, because of a fear of having one of the options immediately being in-the-money.
Stock Trader: Yes, that is probably what I would do.
Optionz Traderz: It is definitely un-nerving to have short option positions that have intrinsic value, even for me, after all these years of trading. But I find it is best to avoid letting that fear influence my trades. The strike prices should be based on the probability of the entire trade being profitable, and whether the premium received is worth the risk.
Stock Trader: That’s a good point. I would be tempted to sell a Strangle with strike prices so far out-of-the-money, that there was no chance of either strike price being hit. But the premiums that far out are usually tiny. The higher premiums I would get on a Straddle might make it a better trade.
Optionz Traderz: Yes, like we talked about earlier, some Straddles and Strangles perform almost identically, especially on very volatile stocks. If the market was volatile enough, and there was sufficient time to expiration, you might be able to collect $1 more by selling a Straddle than you would receive for a Strangle with the strikes moved out by $1. In that case, when you planned on selling options instead of buying, the Straddle could make more sense. If we use the DIA example again, you could collect $1.86 more on a Straddle than a $2 out-of-the-money Strangle.
Stock Trader: That makes perfect sense. I would be obligated for an additional $2.00 in intrinsic value when the stock price moved, but I would receive an extra $1.86 in premiums. So I would only be taking on an additional 14 cents of risk but I would have a potential additional profit of $1.86 if the ETF’s price didn’t move at all.
Optionz Traderz: You nailed it! Why leave that extra money on the table when it isn’t causing you to take on much additional risk. It’s all about risk and reward. If it makes sense to buy a Strangle instead of a Straddle, because the small amount of additional reward does not justify the risk of a trend not occurring, then selling a Straddle instead of a Strangle could also make sense. All you need to do is weigh the risk against the reward and decide whether the potential increased reward justifies the additional risk.
Stock Trader: That is fascinating; a Straddle can behave almost the same as a Strangle, when the underlying price moves; but the profit or loss is much different when the price remains flat. So if I combined the two, say by buying a Strangle and selling a Straddle, wouldn’t that guarantee that I would make a profit no matter what?
Optionz Traderz: Hold on a minute; you’re learning too fast for me again There is actually a name for the strategy you described; an Iron Butterfly. But, like all option strategies, it doesn’t win under all conditions. The Strangle that you are buying will always cost somewhat less than the Straddle you are selling; a net credit trade. Whenever you trade Straddles or Strangles and receive a net credit, you are betting against a trend. The opposite is also true; when you pay a net debit, you are betting on a trend. You receive a net credit when you open an Iron Butterfly, but if either of the options you sold expired with intrinsic value greater than that credit, you would have a loss. I’d be happy to explain Butterflies to you in detail, but it would probably be less confusing if we got through Straddles and Strangles first.
Stock Trader: O.K., you’re the teacherJ
Optionz Traderz: When choosing strike prices for a Strangle, some traders prefer buying a Put at a strike price near a recent support level and a Call at resistance. The premiums are much lower with these options being so far out-of-the-money, so there is much less capital at risk. The downside is that both options will usually expire worthless. But when they do pay off, the profits can be huge.
Stock Trader: And the same would go for selling a Strangle; a Put at support and a Call at resistance would probably both expire worthless most of the time.
Optionz Traderz: Yes, whether you sell a Straddle or a Strangle, you are betting that a stock, or the market as a whole, is range bound. How wide that range is will be determined by the strike prices of your options; the further out-of-the-money you go, the wider the range. There may actually be times, like when the Dow was whipsawing violently recently, that Implied Volatility increases to a level that makes it possible to sell a Straddle and still keep your range of profitability in between support and resistance. Other times you may have no choice but to use a Strangle, if your goal is to include support and resistance levels within that range.
Stock Trader: I think I understand now; buying Straddles or Strangles is a ‘trendish’ strategy and selling them is a range bound strategy. The strike prices determine how ‘trendish’ or range bound I am predicting future prices to be.
Optionz Traderz: Correct; so now that you understand when to use each strategy, you need to consider the time frame of the trade. Option combinations react much more slowly to changes in the underlying price than single options. For example, when you open a Straddle, Delta on the call is normally close to 0.5 and on the put it is about -0.5; the position is initially nearly Delta neutral. So, even if the underlying price did move, the combined position wouldn’t change in value much due to Delta, unless the magnitude of the move was great enough. In the meantime, Theta would be eating up some of the value.
Stock Trader: I guess we’re back to matching the expiration date of the options with the expected time frame that any prediction about a stock’s price would be valid.
Optionz Traderz: That is one way to look at it. But you don’t need to limit yourself to that time frame. As with all option strategies, Straddles and Strangles behave much differently depending on their expiration date. A Straddle with a near month expiration will be much more sensitive to time decay than one a few months out; but it will capture moves in the underlying price much more closely. Also, the near term Straddle would be much less sensitive to changes in volatility. You need to weigh the risks associated with each.
Stock Trader: So if a stock was range bound and I sold a Straddle one month out, I would benefit much more from time decay than if I used options two or three months out, but I would be taking on more risk if the stock broke out.
Optionz Traderz: That is true; so you may want to adjust your position size to compensate for the additional risk.
Stock Trader: Good point! If I am making more profits from faster time decay, by selling options with shorter terms, I don’t need to sell as many contracts.
Optionz Traderz: You can also use the faster time decay another way. Let’s say you noticed that one of your favorite stocks normally remained range bound for about three months after each earnings announcement. Perhaps, after the announcement in October, you were looking to sell ten Strangles with January expirations. Let’s assume each Strangle would get you $2 per share in premiums. Also assume that they would lose about 10% of their time value in the first month, if the underlying price and volatility remained stable. How much of a gain would you have at the end of the first month? As always, there are 100 shares in one option contract.
Stock Trader: LOL, another math problem. O.K. $2 x 10 x 100 = $2000. 10% of $2000 is $200. So I would only have a gain of $200 after the first month?
Optionz Traderz: JYou are getting better at math. Now assume that the premium on the November options was approximately half that of the January options with the same strike prices. How many November strangles would you need to sell in order to earn $200 by expiration day?
Stock Trader: I think I can do this. Each strangle would have a premium of about $1; so $100 per contract. That means I could sell two Strangles with the November expiration and potentially have the same $200 profit after the first 30 days as if I had sold ten Strangles with the January expiration.
Optionz Traderz: Exactly. The good news is that, if the stock remained range bound, and the November options expired worthless, you could probably still sell ten Strangles at that point, with the January expiration, and get the remaining $1800 in premiums you were originally seeking.
Stock Trader: That is really interesting. The profit would be the same, but I would have substantially decreased my risk during the first 30 days.
Optionz Traderz: That’s what trading is all about; seeking out the best profits with the least amount of risk possible.
Stock Trader: So how would you suggest managing a Short Straddle or Strangle once the trade is open?
Optionz Traderz: Just treat each leg of the trade as if it were a single Naked Put and Naked Call. Cut your losses on the losing side when you are able to do so, and take your profits on the winning side when your technical indicators tell you that the time is right. Just as with any Naked option, you also have the choice of rolling the losing leg to a farther-out expiration date and a smaller number of contracts, or a more favorable strike price.
Stock Trader: I think I’m starting to see a theme here. It doesn’t matter what strategy I am using; the basic rules are the same. All I need to do to succeed is choose the correct strategy for the current market conditions, increase my probability of a profit by choosing the appropriate strike prices, limit my losses by selecting the best expirations, manage the trades with stop losses or by rolling, and take my profits off the table the same way I would if I was trading stocks.
Optionz Traderz: That is there is to it. When you trade options, the current condition of the market is always a concern, but never a major problem.
Stock Trader: Professional option traders really have the good life.
Optionz Traderz: It can be a good life, but it takes some work. My Long Straddle on DIA worked out very well this week, but it could just as easily resulted in a big loss. In fact, it was such a big win that my girlfriend and I are going out in my Cadillac later today to celebrate.
Stock Trader: So you celebrate all of your winning trades?
Optionz Traderz: Oh, by no means. I have winning trades all the time. But some trades take a lot of work. I started working on my DIA options trade weeks ago, and endured some initial losses. There were times that it looked as if it would be a total loss. But, my system told me to stick with it, and I did; and the result was a big win. I’m not going out to celebrate the win itself, I’m going out to celebrate the success of the system.
Stock Trader: I know how you feel. I like it when my stock trading system has a big win; it makes all of the previous losses tolerable.
Optionz Traderz: Yes, losses are part of the business, and they are frequent. When the hard work finally pays off, and the system proves that it works, why not celebrate?
Stock Trader: I agree. Enjoy your night out and congratulations on a nice trade……..again.
Optionz Traderz: Thanks.
To read the full book and for a better understanding of options consider purchasing “Show me your options” by Steve Burns and Christopher Ebert from Amazon.com or any other major internet retailer.