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.

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.

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