Long Straddle – Higher Volatility Options Strategies Part 5
Long Straddle – Higher Volatility Options Strategies (Part 5)
Remember, options are priced based on that expectation. Then it leads us to the best strategies to use for that type of analysis that doesn’t have a direction attached to it. And that’s the long straddle and long strangle. Long straddle being, buying a call and put at the same strike, usually at the money and definitely with the same expiration date. Long strangle, buying a call and a put, so just a cousin trade very related to each other. But different strike prices, and usually using out of the money options.
The idea here is, as with any time you’re buying options, you want movement in the stock price. The title of the presentation was long volatility strategies. Well, anytime you are long options and net long options, you’re going to have a long volatility strategy. These are the most direct and cleanest entries for that motivation. So, these strategies are widely used for particular events. An upcoming binary events of some kind that you think is going to move the stock price in one direction or the other, you’re just not sure which one. When you’re evaluating the price of these strategies, I’ll just repeat, you are looking for a bigger move in the stock then the options market is predicting.
Let’s walk through p&l graphs and a fictitious situation with each, and then I can throw in some more some more details. Here, we have Rosario who’s looking at the market and investigating a stock with a symbol JETX. And there’s an upcoming announcement, if sales and revenue beat expectations she’s expecting the shares to take off. And if they’re weak, she’s expecting shares to decline sharply. With this forecast, the straddle or the strangle would fit. The next question is, does the present price makes sense? And, is the price something that this investor feels like is worth trading. So, here’s the example of the straddle. Stock’s at 87 half and the straddle is defined as buying both the call and the put at that strike price. And in this case, we’re going to pay $4. The maximum gain is unlimited because of the upside. There’s no cap on how high the stock can go.
As with any time we’re buying options, the most we can potentially lose is what we paid for it. In this case, that’s four dollars. We shouldn’t have to pony up any more money in our account than that and we have breakeven points on either side of that. Few things about strike and expiration here. For the straddle, it’s assumed that the at-the-money strikes are going to be used. There’s a couple of reasons for that. I already outlined one of them. Vega is greatest at the money, and that is what we’re trying to capture here. Remember, these are long volatility trades and we’re expecting larger movements and increases in volatility. So, we don’t know where it’s going but we think volatility is going to jack in the future. So, we buy at the money which gives us the greatest Vega exposure. It also gives us that ability to go in either direction.
If we chose to use an out of the money strike, then not only would our Vega exposure be less. We’d also gradually start to incur a higher cost, on higher net out-of-pocket cost, because we’ll be paying intrinsic value on one side or the other and we’ll also have Delta exposure. We’ll have long or short Deltas, which means we now have a market bias one way or the other, and that throws off what the analysis is. If you do have that bias in one direction or the other, then you might look for a strategy to benefit from a movement in that particular direction. The long straddle is really neutral. So, at the money is almost exclusively used because it has the greatest Vega exposure and gives you that either direction feature.
Expiration date is rather simple. It’s usually right after the binary event. There is some wiggle room for the investor to evaluate how much time they want after the event. It might just be a day or two or you might want to give the stock some time to run after the announcement. We see that on a regular basis, after a binary event that a big announcement, a move occurs and then that move may continue on for some time, days or weeks. There is some flexibility on how the investor interprets where they want that expiration date to be. One other thing I want to say, because I keep mentioning binary event, you could interpret and I’m being kind of generous here and very loose with it.
You could interpret a technical study as a binary event. For example, if you think the stock is just about to hit a very crucial key resistance, level and it’s either going to fail miserably or it’s going to break that resistance and take off to new highs. You could interpret that as an opportunity to trade the straddle, at that price right where that resistance level is. If the stock’s bumping its head up at 90 and you think this is either going to get knocked down or take off from here. That could be looked at as an opportunity to play a straddle for a big move upcoming. The timing may be a bit difficult in those circumstances where you’re using technical analysis, but you certainly could do it. So, the p&l graph of the long straddle, here you go. At the money, you have your strike price of 87 half and that’s the worst-case situation. 87 half, both options are worth nothing and we lose everything we put into it. In either direction we start to gain, and of course I have to say these expiration graphs are drawn with time value being at 0. They can only be drawn at expiration, because we don’t know what the values of these options would be prior to that. If it’s a long vol trade and we want to see movement after an event and we’re anticipating getting out of the trade prior to expiration, then you take this P&L graph and you understand it, but you expect to manage the position before that.
If we do hold this through expiration, like many option strategies, you may manage it differently depending on what side of the at the money strike we’re on. If the stock is lower and you want to continue this trade, you may be less inclined to go ahead and exercise the put into short stock. Many investors don’t take that route. So, you may need to look for another way to get short Deltas and continue the trade from there. But on the flip side of that, if the stock is higher and we think it’s going to keep going higher and we’ve reached expiration. We don’t have anymore time, and this is certainly possible, if you choose an expiration just after the event and there’s a big move and you think is going to keep going and I want my Delta’s. Then some sort of position management up there might be necessary and it could include ponying up for the shares.
If you’re confident in the move, and you go ahead and buy the shares and keep the stock, keep capitalizing on the stock move higher. Or you can look for another way to gain your positive deltas and long delta exposure. Now one thing you might have heard through television articles or economist, they may have referenced the options market predicting. What the option market tells you is the expected move in a stock after a particular event. In this case this binary event. You may have heard them say the options market is predicting the stock is going to move 8% after earnings or something like that. It’s kind of a common thing for you to hear on TV or something like that. And really there’s two different ways that calculation can be made, but here’s the simple one just using the straddle itself. If this is our situation, with the stock at 87 half and we have to pay four dollars, that means the stock can move in for dollar move within a four dollar range in either direction that breaks even. Well, that’s about four and a half or so percent in either direction for us to break even on this trade. The buyers always break even at a four and half percent move and that’s you can interpret that’s what the options market is doing and that’s what those statements mean. And in this case the options market is predicting a four and a half percent move in this particular stock after the binary event and again stipulating that the binary event is going to be very closely before the expiration date of these options.