Long Straddle - worth adopting?

[Kruegs]

Hi there,

I have been dabbling in Options the last year or so, just buying a few Calls and Puts ... with some success. I went to one of those Optionetics seminars the other day (don't worry.. I haven't 'signed up') but went away thinking about the Long Straddle concept. The strategy I was thinking of developing runs along these lines :

- Analyse market fundamentals to look for stocks that are are either volatile and moving already, or look likely to have a trigger event (eg: reporting season, announcements) in the near future.
- Set up a straddle around the current market price.
- Let it run for a few weeks, and especially over any 'trigger event' that is anticipated.
- If it moves significantly, then well and good. If not, then close out the Options before the theta-effect takes hold to minimise loss.

The downside I see with this strategy is that stocks generally need to move A LOT in a short period of time for a real profit to be made, often in the vicinity of 15-25% of the value. Would this be a fair statement, to the point that a strategy of working straddles is unlikely to deliver any real profit when treated in an across the board fashion? The bloke at the Optionetics seminar seemed to indicate that the Straddle would deliver a good profit often enough to significantly outweigh small losses, but I am not entirely convinced of this as yet?

Finally, I would have to ask your advice as to whether this strategy is a good, minimal risk way to learn the discipline and analysis techniques required to trade options successfully (using other strategies?

Anyway, I look forward to hearing peoples view and experience on this approach?

Regards,
Mark Krueger

 

[wayneL]

The old optionetics straddle eh?

The think with straddles is that you have to make a balance between three greeks. Theta, Gamma and Vega.

Theta/Gamma - trying to minimize theta by going out in time will significantly reduce gamma and gamma is the function by which you profit from move. So the stock has to move A LOT.

Trying to maximize gamma means you have to come closer in time. Of course then you start getting eaten alive by theta. Striking a balance here is important.

Vega - Whether realized or not, every option trade is also a volatility bet, especially so with straddles. If you buy a straddle, you have double vega (sensitivity to volatility changes) so you better hope volatility increases, if volatility drops, you get creamed. The further out in time you go the more vega increases the more the straddle is a volatility bet.

Buying straddles before earnings can be a very bad idea. For an illustration of this see this post on my options blog http://sigmaoptions.blogspot.com/2006/12/nike-straddle-just-do-it.html

There are more considerations, but you get the idea. If all the greek stuff sounds like gobbledygook, then you really need to learn about it before trading further.

Good luck

 

[bingk6]

Great advice Wayne. Certainly a lot of greeks to contend with in a straddle. I do have one question for you though, in your blog you mentioned "When earnings are released IV crushes.". Why is that ? Is it more a case of all the players anticipating that the stock will move during an anouncement and therefore IV creeps up, in anticipation, as the announcement date approaches, but then when the anouncement actually takes place, it turns out to be no big deal or the news have all been largely factored in and therefore IV drops significantly. A bit like "Buy the rumour and sell the fact". From your experience, is this IV crush after earnings a common occurance ?

 

[wayneL]

Great advice Wayne. Certainly a lot of greeks to contend with in a straddle. I do have one question for you though, in your blog you mentioned "When earnings are released IV crushes.". Why is that ? Is it more a case of all the players anticipating that the stock will move during an anouncement and therefore IV creeps up, in anticipation, as the announcement date approaches, but then when the anouncement actually takes place, it turns out to be no big deal or the news have all been largely factored in and therefore IV drops significantly. A bit like "Buy the rumour and sell the fact". From your experience, is this IV crush after earnings a common occurance ?

There are two schools of thought on this.

1/ Because an announcement is imminent and a possible large gap of either direction, buyers pile into the market to hedge, speculate on a humungous move while protecting capital, or have been to an optionetics seminar and buying straddles; forcing the prices up via supply and demand.

2/ Sellers of options, aware of a possible large volatility spike, refuse to sell cheaply and demand higher prices for the risk they are taking.

I think it's a combination of the two.

Volatility rise is almost obligatory where the announcement is expected to have a profound effect on share price.

Volatility crush is almost universal as subsequent volatility is likely to return to normal.

Remember, Implied Volatility is an attempt by the market to predict the future volatility, rather than measure historical volatility.