Follow Us: TwitterFacebookRSS feed

Does Your Option Trading Use Straddles or Strangles?

Posted by Pete Stolcers on October 14, 2006

Option Trading Question

In today's option trading blog I will answer a question submitted by Robert F., “Do you trade straddles? If so, what is your setup, entry and exit.

Option Trading Answer

I will group straddles and strangles together since they are closely related. For those of you who aren’t familiar with the option strategy, a straddle purchases the puts and the calls with the same strike price in the same month. A strangle purchases puts and calls that are separated by at least one strike price but they expire in the same month.

For example, let’s say that a stock is trading at $45. A straddle would purchase both the November 45 puts and the November 45 calls. A strangle would purchase the November 40 puts and the November 50 calls. Both strategies want a big move in either direction. It doesn’t matter which way, it just has to be big. In the example above, if the stock trades down to $35, the calls will expire worthless, but the puts will make enough money to more than cover the cost of the entire position.

While it is possible to sell straddles and strangles, the risk is unlimited and most brokerage firms will only approve experienced, well capitalized traders for the strategy. In that light, I will assume that the question is asking me if I buy straddles or strangles.

Less than 2% of my trades fall into this category. This is a non-directional trade and I would only use it if I do not have an opinion of where the stock will go. The premiums are expensive since I have to pay for both the calls and the puts. I would rather look for an opportunity where I feel I can predict the outcome.

My only straddle this year was on Bausch and Lomb (BOL). They were under SEC investigation for sales reporting practices and they had delayed their quarterly earnings indefinitely. During the wait, they announced that their contact lens solution might be causing eye infections and the product was pulled from shelves in India and China. The pressure was building and the earnings release would include guidance/explanations. In March, I bought the April 65 straddle ahead of the news and I paid $6.50 for both the puts and calls. The calls expired worthless and the puts went to $18. You can see the chart of BOL on my home page. It is the 10th flash video. You also can read my analysis in the Daily Report (reference 3/07/2006).

If you are going to trade the strategy, you have to look for a number of things. The stock has to provide some reason for you to believe that an explosive move lies ahead. An earnings miss, FDA approval/rejection for a new drug, a patent settlement all of these would qualify as material events that would lead to an explosive move. Remember that Market Makers and and trading firms have better information than you or I and they will “jack” the premiums up ahead of the event to compensate for the risk. They have statisticians working on the probability of the outcome and they estimate where the stock should be trading. That makes it even harder to make money with the strategy.

I also look for a very wide trading range for the stock. A $70 stock that has ranged from $40 - $100 tells me that it has room to move either way. Based on the historical price movement there is not a consensus on where the stock should be valued. Remember, if you are long a straddle/strangle - you want uncertainty and explosion. Anything less and you will lose money.

There is one more element. You want the implied volatilities (IVs) of the options to be as low as possible. Guess what, on a macro basis, the IVs are at historically low levels for stock overall. This is a buyers market!

Instead of being long a put and a call on the same stock, I would rather be long a put on a stock that is relatively weak and long a call on a stock that is strong. Also keep in mind that I don’t trade earnings announcements, they are too much of a crap shoot. Now that I’ve set the table, I’m going to conclude this blog and see if I can find an opportunity. I hope to find one today, but if not, keep checking the blog.

Option Trading Comments

  • On 10/18, Mike said:

    Just wanted to add to the excellent article that even with a big move, you can lose money...It’s happened to me, and you can see it with RIMM, AAPL, GOOG as well. <br><br>Several times before earnings announcements the premiums are so high, that even with a five or seven percent move in the stock, the next day all the implied dissipates right after the open, and unless you have a large number of contracts (I only like to buy one or two), the commissions often eat up the difference because the prices adjust so dramatically. It’s really frustrating and aggrivating when you don’t know what’s going on! I thought the quote screens were wrong my first couple times.<br><br>I now prefer to do straddles on events for stocks that aren’t so momentum-heavy, don’t normally make such big moves or have such high volaitility.

  • On 10/18, Mike said:

    Other candidates are those on which you are bullish, analysts are negative but are in an uptrend, with high short interest...then you have a chance of a short squeeze on your side. Also, if you have contracts that expire soon (say a week or less), watch very closely what happens after the open...several times I have seen an initial move reverse course about half an hour to an hour after the open! With those it is possible to make profits on EACH side of the straddle/strangle, but you have to be QUICK, able to turn on a dime, and not worry about leaving money on the table since you will not hit the exact highs or lows. (For me, the toughest psychological obstacle to overcome...selling at a small profit and watching it turn into a larger profit mere hours or even minutes afterwards...Yet pro traders somehow deal with it easily. Must be nice!)

  • On 05/30, said:

    To execute a spread trade, the investor must buy an option at one strike price, then sell an option at a strike price that is farther out-of-the-money (both contracts should expire in the same month). Since this type of trade involves the sale of an option, the trader will receive initial income from this transaction. The income received will not be enough to offset the cost of buying the first option, but it will lower the overall cost of the trade. However, in exchange for this lower transaction cost, the investor will essentially forfeit any gains that he/she would have earned above a certain set level.

  • On 05/09, Lingzi330 said:

    Dear Pete, I have been reading your blog and find they are veyr helpful. Here is my question. Looking forward to get your help.Thanks.

    2. for strangle, as the following example:

    XYZ stock is trading at 3.94 now

    strike price is $3, $4 , $5

    The following strangle, which one is correct ?

    1) OTM Call $4 + OTM Put $3 to form a strangle

    or 2) OTM Call $5 + OTM Put $ 3 to form a strangle

    The following straddle, which one is better choice? why?

    1) $3 Call + $3 Put

    2) $4 Call + $4 Put

    Which strike price is called ATM strike price ? $3 for call or $4 for put?

  • On 05/11, Pete Stolcers said:

    Every trading decision is a function of your expectations for the stock. You would have to do your analysis and determine the probability for a big move in either direction. Know the factors that would drive the stock in a particular direction and by how much.  You would also need to determine the probability of the stock moving through various price points and you need to nail down a time frame. This is exactly what the Market Maker firms do when they price the options and they have a research team working on it.

    I am not a big fan of neutral trades like this. I find opportunities where I can predict a directional move and then I take a stand.

  • On 07/15, ng wern chin said:

    Dear Pete,

    This is a simple question. In July, the option expire on 17. Can we still trade the option on that day? If not, then, is the last trading of option for July end on Thur the 16th?

    thank you

  • On 07/16, Pete Stolcers said:

    With the exception of a few indicies, the options can be traded right into the closing bell on the third Friday (17th in this case).

< Back