From time to time we’ll break away from talking trades to discuss different option trading strategies. Being in the midst of earning season, I think it is important to address the straddle/strangle strategy, since I am getting a significant number of questions regarding these types of trades.
Before we start, let me say that option pricing is a complex topic, and one that you should try to learn inside and out while trading options. If you have an understanding of how options are priced, you’ll be able to determine which strategy is most appropriate and when. We’ll do lots of work on this from time to time, so be prepared to learn.
The reason traders want to trade over earnings is due to the large price swings that are made. The problem with options is that a significant portion of the premium is based on expectations. In short, if you are expecting big price swings, so is the market. Therefore, option premiums take this expectation into consideration and price an “expected move” into the premium.
A straddle is an option strategy where you are buying a call and a put of the same expiration and strike price. A strangle is an option strategy where you are buying a call and a put of the same expiration and different strikes. You can also sell straddles and strangles, but the risk profile is extreme for traders, and ultimately should be avoided. In this post we’ll focus on the long side of this position.
As the buyer of an option, you are paying premiums that have an expected move “baked in” to the price of the option. Not to mention, as the buyer of a straddle or strangle, you are trading two overpriced options where the anticipated move is priced in. This means you have a pretty low probability of success.
To improve the odds of success, you implement these strategies when options are relatively or historically cheap. This strategy works best when you are anticipating a rise in implied volatility (expectations) and stand to benefit in changes in prices as well. Take a look at this chart. This chart reflects the changes in implied volatility for AAPL.
Pay attention to the gold colored line. It reflects fluctuations in implied volatility. The four arrows on the chart reflect where AAPL reported earnings. You’ll see in the last three earnings releases, implied volatility has been at the upper end of its relative range. Today, implied volatility is closer to the bottom of its range.
What this means is that expectations and option premiums have been high into the last three announcements. This time around, they are significantly lower. This interests me. As an option trader, you should live by the mantra “buy when premiums are cheap, sell when they are expensive.” Premiums are relatively cheap here.
While I am not too excited to place bets on both sides of AAPL, I am seriously considering taking a position here into earnings. For the most part, I loathe this idea. I hate to see traders gamble into the face of the unknown, when premiums are stacked against you. However, I like the fact that they are still relatively cheap here, and the general sentiment surrounding this stock.
Final thought: waiting until the last minute prior to an earnings release to buy options is a terrible strategy, generally speaking. However, always pay attention to implied volatility. If you are looking to trade straddles or strangles, buy them in advance while premiums are cheap, or just avoid trading them when they are too expensive.
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what about condors and/or butterflies?
Can I ask what turned you on to them first?
because overreactions are rampant in the market and getting long a butterfly allows you to profit when future realized vols are lower than implied vols.
Great answer.
Make sure you have a great commission rate.
Thanks for the lesson. I will read it several times. Much appreciated!
could never understand why people put on a straddle.either way it goes,one cancels out the other.seems like a waste of money.specially at the same strike.
if the move is big enough it will work.. anyway OA when is the premium service coming out. =d
“could never understand why people put on a straddle.either way it goes,one cancels out the other.seems like a waste of money.specially at the same strike”
you need to reread the post, you obviously do not understand that you are making a play on volatility (meaning the price can go up or down but you do not know which way) since you have no directional bias you buy the same strikes so no ground is left uncovered, you make caysh if u cover the cost of both premiums
hey poop,for the seven years i’ve been involved with options,this is not the first time that that same statement/debate about a straddle has come up,volatility you say,one Q for ya?if my put goes tits up,and my call get castrated, then where’s my profit? where a straddle works,is when there is a complete imbalance between the put/call price at the same strike.ie: when citi was at 40 ,and the 08 crash came i was lining up puts up and down the chain thats when you saw a complete disconnection between the price of puts verses calls,lets say 35 puts where costing me 1.50,and calls were .45 cents thats when,and only then, you’ll make big time bucks. i shorted citibank from 40 bucks,all the way down to 5 dollars,and i did it with 34 bucks the whole time between 08 and until almost march of 09.then i put on a leap for two years out at the 5 dollar strike………..more fun than i ever had…….keep your straddle……..i have spent a great amount of time studying option chains,just the chains.i can look at nothing else but an option chain for any given company with out researching anything else and know pretty much how good/bad the bet will be.
I agree that there is more profit to be made when the slope of the volatility skew increases in your favor, however for Apple right now, the chain is more of an even vol smile (or close to it)….so after Apple announces earnings, both of your positions should not cancel out, once the move has covered the combined premium prices you will see profits….the situation you had with Citi is not necessarily relevant to putting a straddle on Apple in to earnings this quarter….the market is so torn about Apple right now that it seems like an appropriate strategy
OA, quick question for you. Any idea on how to determine when the next available options will be published for a particular equity? Or leaps in particular? Thanks in advance.
Yes, you can tell by the months available what ‘cycle’ they are on. If weeklys are offered, they come out Thursdays. LEAPS will be January expirations for the next two years out.
Front month and following month will be available on everything, no matter the cycle.
Cycle as in every three months…JAJO, MJSD, FMAN (feb, may, aug, nov)
Appreciate the post OA. If you are up for it a post trade analysis of what you did would also be appreciated. GL today
Shit, iBankCoin is getting real Hyphy. Mac Dre avatarts!
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