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Long Straddle Options Strategy: The Ultimate Guide
Pat Crawley posted a article in Trading BlogFor example, if the SPDR S&P 500 ETF (SPY) trades at $396 per share, we expect a significant move in the S&P 500. Still, we're unsure of the direction of said move. We might purchase an at-the-money (ATM) straddle, which involves buying an ATM put and call. In this case, we’d buy the following options: BUY 1 396 Put @ $8.06 BUY 1 396 Call @ 9.31 Total trade cost: $17.37 (net debit) As you can see, in buying both an at-the-money put and call, we profit from significant price moves in either direction. However, this comes at a high cost, as you can see by the considerable premium outlay of $17.37, accounting for a bit more than 4% of the total underlying stock price. For this reason, we'd need a significant move in SPY for our position to show a profit. Characteristics of a Long Straddle The Long Straddle is Market Neutral A long straddle is a market-neutral option spread, meaning it makes no attempt to predict the future price of the underlying stock. Instead, the idea is to profit from a significant price move in the underlying stock, regardless of whether it moves up or down. For example, let’s say we purchase the long straddle on SPY that we referenced in the introduction to this article: SPY Long Straddle: BUY 1 396 Put @ $8.06 BUY 1 396 Call @ 9.31 Total trade cost: $17.37 (net debit) If the price of SPY soars over the month, our call option will become profitable, and we can sell it for a profit. The reverse is true for our put option. In either case, we will make money if the price move is more significant than the price of the options we purchased. While some traders prefer to forecast the price of stocks using technical or fundamental analysis, many seasoned options traders take solace in not having to predict where the price will be next month to make money in the markets. A market-neutral strategy like the long straddle instead forecasts the future implied volatility of a stock. Maybe that just seems like a different type of prediction. There's good reason to believe predicting future volatility is more manageable than forecasting future price direction. While stock prices can go seemingly anywhere, volatility pricing is much more rhythmic. There’s considerable academic evidence that volatility clusters in the short term and mean-reverts over more extended periods. In other words, there's a discernable pattern to market volatility that shrewd traders can profit from. The Long Straddle is Long Volatility Being "long-volatility" in the options market is synonymous with being a net buyer of options, or simply, "long options." The critical aspect is that the long straddle is a play on volatility rather than price, making the trade vega positive. In the options market, an at-the-money (ATM) straddle best represents the options market's estimation of future volatility, also known as implied volatility. An easy way to escape all the jargon and technical minutia of the options world is to think of the ATM straddle as the over/under on volatility for that stock. Allow me to explain. Let's return to our example in the S&P 500 ETF (SPY). To remind you, here is the ATM straddle pricing for options expiring in 25 days: SPY Long Straddle: BUY 1 396 Put @ $8.06 BUY 1 396 Call @ 9.31 Total trade cost: $17.37 (net debit) With our trade cost at $17.37, SPY has to move at least $17.37 in either direction within 25 days for us to profit from this trade. Is that a lot or a little? This is where your trading skills come in. Options traders use a variety of factors to determine if a straddle is appropriately priced, including where implied volatility is today compared to its historical range, their technical analysis view, how they think the market will react to upcoming events like Federal Reserve meetings, and so on. Long Straddles Have Defined Risk Because the long straddle involves buying a put and call, the maximum risk is defined. It's simply the combined cost of the two options. This provides a significant advantage, as you can be absolutely sure of your worst-case scenario in a long straddle. Unlike short options strategies, like the short straddle, which have unlimited and undefined maximum risk levels. For this reason, long straddles are often some of the first spreads that novice options traders begin to experiment with beyond simply buying single puts or calls. It’s just like what they’re used to doing, except it removes the directional element. Returning to our SPY example from before, the max we can lose in this scenario is $17.37. The Long Straddle Has Unlimited Profit Potential The long straddle has theoretically unlimited upside profit potential. This means that if the underlying stock makes a big move in either direction, nothing stops your profits from going on forever, except the stock price goes to zero on the downside. The Long Straddle Suffers from Time Decay (Short Theta) When you buy options, you’re betting against the clock. The underlying stock must make your desired move before it expires, or else the option will expire worthless. This concept is known as “time decay,” or the more technical term, “theta decay.” Theta is the Options Greek which measures an option position's exposure to the passage of time. The great thing about the options Greeks is you can mathematically derive them. So you know exactly how much an option position will lose per day from the passage of time if all things remain equal. If we return to our SPY long straddle example: SPY Long Straddle: BUY 1 396 Put @ $8.06 BUY 1 396 Call @ 9.31 Theta: -0.34 Total trade cost: $17.37 (net debit) The position has a theta of -0.34, meaning the position will lose about $0.34 in value per day until expiration. Keep in mind that theta changes over the life of an option. As expiration nears, the value of theta declines, as there is less time value in the option. So the daily decay will be lower in absolute terms. Still, it can often be higher in terms of the percentage of the position's value if the underlying stock hasn't moved in your favor. The following chart from Investopedia should put things into perspective: Source: Investopedia How to Create a Long Straddle position The long straddle is one of the simplest options spreads out there. It just consists of a long put and call. Here’s what a long straddle might look like on an options chain: As you can see, we're buying a put and call at the same strike at the same expiration. The above example shows an at-the-money (ATM) straddle. However, you can structure a straddle to better fit your market view. For instance, if we move the strike price of our straddle higher, it'll become more profitable on the downside quicker and take a more significant price move for it to become profitable on the upside. The opposite of this is also true. Long Straddle Payoff and Max Profit/Loss Long Straddle Breakeven Prices The long straddle is very easy to calculate breakeven, max profit, and max loss levels for. This is another reason it's an excellent spread for novices to begin to dip their toes in options spread trading. As an example, we’ll use our SPY long straddle again and calculate the various levels for it: SPY Long Straddle: BUY 1 396 Put @ $8.06 BUY 1 396 Call @ 9.31 Theta: -0.34 Total trade cost: $17.37 (net debit) To calculate the upper breakeven price for a long straddle, simply add the total premium paid to the strike price. In this case, you simply add $396 + $17.37 = $413.37. Our upper breakeven price is $413.37. The lower breakeven price for a long straddle is equally easy to calculate. You simply subtract the total premium paid from the strike price. In this case, that is $396 - $17.37 = $378.63. To contextualize these prices, I’ll plot them on a chart of SPY: The thick dotted lines represent the upper and lower breakeven prices, while the vertical black link represents the expiration date. The price of SPY needs to exceed either of these levels for our hypothetical long straddle position to show a profit before expiration. Long Straddle Maximum Profit This one is easy. The maximum upside profit for a long straddle position is theoretically unlimited. There’s no limit to how high a stock price can go. However, on the downside, your max profit is only limited by the stock price. Because a stock price can only go to zero, you can calculate the max profit by subtracting the total premium paid from the strike price. In this case, the strike price is $369, and the total premium paid for our SPY long straddle is $17.37, so the max profit from the stock declining is $378.63, which is the same as our lower breakeven price. Long Straddle Maximum Loss/Risk Because a long straddle involves buying two options, no formulas are required to calculate your maximum risk. The maximum risk for this position is the total premium paid. In our SPY straddle example, that is $17.37. However, the absolute maximum loss in a straddle is pretty rare, as you’ll see when we show you the payoff diagram of the long straddle. Long Straddle Payoff Diagram The long straddle payoff diagram is characterized by a V-shape. This is unlike the straddle’s sister spread, the strangle, which is marked by a flattened U-shape. Here is the straddle payoff diagram: Let’s look at a real-life example of a long straddle payoff diagram, using our SPY straddle as an example. As a reminder, here is our SPY long straddle position: SPY Long Straddle: BUY 1 396 Put @ $8.06 BUY 1 396 Call @ 9.31 Theta: -0.34 Total trade cost: $17.37 (net debit) Long Straddle: Market View Why Matching Your Market View to Options Trade Structure is Crucial One thing we're trying to nail home in this reverse straddle primer is the importance of matching your market view to the correct options spread. As an options trader, you're a carpenter, and option spreads are your tools. If you need to tighten a screw, you won't use a hammer but a screwdriver. So before you add a new spread to your toolbox, it's crucial to understand the market view it expresses. One of the worst things you can do as an options trader is structure a trade that is out of harmony with your market outlook. This mismatch is often on display with novice traders. Perhaps a meme stock like GameStop went from $10 to $400 in a few weeks. You're confident the price will revert to some historical mean, and you want to use options to express this view. Novice traders frequently only have outright puts and calls in their toolbox. Hence, they will use the proverbial hammer to tighten a screw in this situation. In this hypothetical, a more experienced options trader might use a bear call spread, as it expresses a bearish directional view while also providing short-volatility exposure. But this trader can be infinitely creative with his trade structuring because he understands how to use options to express his market view appropriately. The nuances of his view might drive him to add skew to the spread, turn it into a ratio spread, and so on. What Market Outlook Does a Long Straddle Express? A trader using a long straddle expects a significant increase in implied volatility and/or a significant price movement and has a neutral directional view. Significantly, a trader who buys a straddle should have a bullish view of volatility. Buying both an at-the-money (ATM) put and call is a considerable premium outlay, so having the view that volatility is cheap isn't enough to justify buying a straddle. You must expect a huge price move. Furthermore, it's essential to view volatility in relative terms. While 50% implied volatility might be very high for a stock like Philip Morris (PM), that might be historically low for a stock like Tesla (TSLA). When To Use a Long Straddle While there's an infinite number of scenarios where a sophisticated options trader can profitably buy a straddle, there are two basic scenarios where it makes sense to buy a straddle. The first is when implied volatility is at the bottom of its historical range as measured by something like IV Rank or something similar. The second is when there’s an upcoming catalyst that you think the options market is underpricing the volatility of. However, when it comes to event volatility, we find that it's too hard to predict. We'd rather exploit how options markets tend to price event volatility over time rather than predict how the market will react to a blockbuster data release. We'll demonstrate this point by discussing how we trade pre-earnings straddles. Buying Pre-Earnings Straddles Earnings releases are the most common form of straddle trading. Companies report earnings four times per year. A simple glance at a stock chart shows that these one-day data releases are often accountable for a large portion of the stock's annual price range. The typical way options traders play earnings is to identify stocks with consistently underpriced earnings volatility. These stocks change over time, as the market eventually adapts and market makers appropriately price volatility. However, the glaring issue with earnings straddles is IV crush. As soon as the market digests the earnings report, implied volatility plummets as there’s no longer lingering uncertainty about a potentially terrible or blockbuster report. Furthermore, there’s a heavy tendency for the market to significantly overprice earnings volatility. This is why we at SteadyOptions prefer to trade pre-earnings straddles. Because implied volatility (and, in turn, option prices) tends to rise in the lead-up to earnings, we prefer to buy straddles 2-150 days before an earnings release and sell before earnings are even released. Pre-earnings straddles also significantly reduce the main risk of the straddle strategy which is negative theta. Rather than making a bet on earnings, we're combining momentum trading and the tendency for implied volatility to rise in the lead-up to earnings. We're simply exploiting a repeatable tendency in the options market. This isn't theoretical. You can see the performance of our pre-earnings straddles on our performance page here. We first described the strategy in our article Exploiting Earnings Associated Rising Volatility. Using Straddles to Trade Volatility Mean Reversion Volatility expands and contracts. If you look at a chart of volatility, you'll realize that it seems more like an EKG or sine wave than a stock chart. For instance, as a demonstration point, let's look at the long-term moving average of the S&P 500 Volatility Index (VIX). The following is a 10-week moving average of the VIX going back to its formulation in 1990: Pretty obvious mean-reverting behavior too. And as we mentioned earlier in this article, this phenomenon is supported by popular quantitative finance academic literature. One way options traders might exploit this phenomenon is to opportunistically wait for periods where volatility is very low compared to its historical average. There are several ways to measure this, with IV Rank being one popular measure. Long Straddle Options Spread Example Here is a recent example of our straddle strategy. DIS was scheduled to announce earnings on February 8th. We placed the following trade on February 2th: We paid $6.72 for the 111 straddle using options expiring on Feb.10 (2 days after earnings). 3 hours later we were able to close the trade at $7.40 for 10.12% gain. The trade benefited from the stock movement and IV increase. The Biggest Risk When Buying a Long Straddle Most people buy straddles to participate in event volatility. They're betting that the options market is underpricing the risk of a significant price move in either direction. But everyone in the market knows that this event is coming. Because the event is a source of considerable uncertainty, implied volatilities in the post-event expirations tend to rise significantly as we get closer to the event. However, implied volatility tends to plummet once the event is behind us and the market has digested the consequences. This is IV Crush, an effect we've already discussed in this article. But it's a point that deserves to be driven home. Several backtests show that, on average, holding straddles through earnings (the most popular form of event volatility) is an unprofitable strategy. While there's no doubt that some traders can pick and choose their straddles wisely enough to create a profitable strategy for themselves, we prefer to play the probabilities. Instead, we exploit the tendency for earnings volatility to get more expensive in the lead-up to the event. However, instead of holding through the earnings release, we choose to sell before it. The strategy of buying straddles 2-15 days before earnings and selling before the event is our bread and butter strategy. It can produce 5-10% gain in a short period of time with a very limited risk and also serve as a black swan protection because the gains will be very large in case of a black swan event. Bottom Line The long straddle is a simple option spread. You buy a put and call at the same strike price and expiration. But simple doesn’t mean easy. The bottom line is that the straddle is a bet on significant change. A trader buying a long straddle is betting on the stock's price making a sizeable directional price move or that the options market will significantly raise the price of volatility. The following Webinar discusses different aspects of trading straddles. Like this article? Visit our Options Education Center and Options Trading Blog for more. Related articles How We Trade Straddle Option Strategy Straddle Vs. Strangle Options Strategy Exploiting Earnings Associated Rising Volatility Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? Long Straddle: A Guaranteed Win? Straddle, Strangle Or Reverse Iron Condor (RIC)? Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings Straddle Option Overview Long Straddle Through Earnings Backtest Straddles - Risks Determine When They Are Best Used Long And Short Straddles: Opposite Structures
Why We Sell Our Straddles Before Earnings
Kim posted a article in Trading BlogIn this article, I will show why it might be not a good idea to keep those options straddles through earnings. As a reminder, a straddle involves buying calls and puts on the same stock with same strikes and expiration. Buying calls and puts with the different strikes is called a strangle. Strangles usually provide better leverage in case the stock moves significantly. Under normal conditions, a straddle/strangle trade requires a big and quick move in the underlying. If the move doesn’t happen, the negative theta will kill the trade. In case of the pre-earnings strangle, the negative theta is neutralized, at least partially, by increasing IV. The problem is you are not the only one knowing that earnings are coming. Everyone knows that some stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crushes to the normal levels and the options trade much cheaper. Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In many cases, this drop erases most of the gains, even if the stock had a substantial move. In order to profit from the trade when you hold through earnings, you need the stock not only to move, but to move more than the options "predicted". If they don't, the IV collapse will cause significant losses. Here is a real trade that one of the options "gurus" recommended to his followers before TWTR earnings: Buy 10 TWTR Nov15 34 Call Buy 10 TWTR Nov15 28 Put The rationale of the trade: Last quarter, the stock had the following price movement after reporting earnings: Jul 29, 2015 32.59 33.24 31.06 31.24 92,475,800 31.24 Jul 28, 2015 34.70 36.67 34.14 36.54 42,042,100 36.54 I am expecting a similar price move this quarter, if not more. With the new CEO for TWTR having the first earnings report, the conference call and comments will most likely move the stock more than the actual numbers. I will be suing a Strangle strategy. 9/10. Fast forward to the next day after earnings: As you can see, the stock moved only 1.5%, the IV collapsed 20%+, and the trade was down 55%. Of course there are always exceptions. Stocks like NFLX, AMZN, GOOG tend on average to move more than the options imply before earnings. But it doesn't happen every cycle. Last cycle for example NFLX options implied 13% move while the stock moved "only" 8%. A straddle held through earnings would lose 32%. A strangle would lose even more. It is easy to get excited after a few trades like NFLX, GMCR or AMZN that moved a lot in some cycles. However, chances are this is not going to happen every cycle. There is no reliable way to predict those events. The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit. Jeff Augen, a successful options trader and author of six options trading books, agrees: “There are many examples of extraordinary large earnings-related price spikes that are not reflected in pre-announcement prices. Unfortunately, there is no reliable method for predicting such an event. The opposite case is much more common – pre-earnings option prices tend to exaggerate the risk by anticipating the largest possible spike.” Related Articles: How We Trade Straddle Option Strategy Buying Premium Prior to Earnings Can We Profit From Volatility Expansion into Earnings Long Straddle: A Guaranteed Win? We invite you to join us and learn how we trade our options strategies in a less risky way. Join Us
How We Trade Long Straddle Option Strategy
Kim posted a article in Trading BlogHow long straddles make or lose money A long straddle option strategy is vega positive, gamma positive and theta negative trade. It works based on the premise that both call and put options have unlimited profit potential but limited loss. If nothing changes and the stock is stable, the straddle option will lose money every day due to the time decay, and the loss will accelerate as we get closer to expiration. For the straddle option strategy to make money, one of the two things (or both) has to happen: 1. The stock has to move (no matter which direction). 2. The IV (Implied Volatility) has to increase. While one leg of the straddle losses up to its limit, the other leg continues to gain as long as the underlying stock rises, resulting in an overall profit. When the stock moves, one of the options will gain value faster than the other option will lose, so the overall trade will make money. If this happens, the trade can be close before expiration for a profit. In many cases IV increase can also produce nice gains since both options will increase in value as a result from increased IV. This is how the P/L chart looks like for the straddle option strategy: When to use a long straddle option strategy Straddle option is a good strategy if you believe that a stock's price will move significantly, but don't want to bet on direction. Another case is if you believe that IV of the options will increase - for example, before a significant event like earnings. I explained the latter strategy in my Seeking Alpha article Exploiting Earnings Associated Rising Volatility. IV usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes. This is one of my favorite strategies that we use in our SteadyOptions model portfolio. Many traders like to buy straddles before earnings and hold them through earnings hoping for a big move. While it can work sometimes, personally I Dislike Holding Straddles Through Earnings. The reason is that over time the options tend to overprice the potential move. Those options experience huge IV Crush the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move. Selection of strikes and expiration I would like to start the trade as delta neutral as possible. That usually happens when the stock trades close to the strike. If the stock starts to move from the strike, I will usually roll the trade to stay delta neutral. Rolling simply helps us to stay delta neutral. In case you did not roll and the stock continues moving in the same direction, you can actually have higher gains. But if the stock reverses, you will be in better position if you rolled. I usually select expiration at least two weeks from the earnings, to reduce the negative theta. The further the expiration, the more conservative the trade is. Going with closer expiration increases both the risk (negative theta) and the reward (positive gamma). If you expect the stock to move, going with closer expiration might be a better trade. Higher positive gamma means higher gains if the stock moves. But if it doesn't, you will need bigger IV spike to offset the negative theta. In a low IV environment, further expiration tends to produce better results. Straddles can be a cheap black swan insurance We like to trade pre-earnings straddles/strangles in our SteadyOptions portfolio for several reasons. First, the risk/reward is very appealing. There are three possible scenarios: Scenario 1: The IV increase is not enough to offset the negative theta and the stock doesn't move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days. Scenario 2: The IV increase offsets the negative theta and the stock doesn't move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains. Scenario 3: The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring few very significant winners. For example, when Google moved 7% in the first few day of July 2011, a strangle produced a 178% gain. In the same cycle, Apple's 3% move was enough to produce a 102% gain. In August 2011 when VIX jumped from 20 to 45 in a few days, I had the DIS strangle and few other trades doubled in a matter of two days. The main risk to this strategy is earnings pre-announcements. They can cause volatility crash and significant losses. To demonstrate the third scenario, take a look on SO trades in August 2011: To be clear, those returns can probably happen once in a few years when the markets really crash. But if you happen to hold few straddles or strangles during those periods, you will be very happy you did. Overall this strategy produces over 75% winning ratio with very low risk. It is very rare to lose more than 10-15% using pre earnings straddle strategy. Summary A long straddle option can be a good strategy under certain circumstances. However, be aware that if nothing happens in term of stock movement or IV change, the straddle will bleed money as you approach expiration. It should be used carefully, but when used correctly, it can be very profitable, without guessing the direction. If you want to learn more about the straddle option strategy and other options strategies that we implement for our SteadyOptions portfolio, sign up for our free trial. The following Webinar discusses different aspects of trading straddles. Related Articles: Buying Premium Prior to Earnings Can We Profit From Volatility Expansion into Earnings Long Straddle: A Guaranteed Win? Why We Sell Our Straddles Before Earnings Is 5% A Good Return For Options Trades? Want to learn more? We discuss all our trades on our forum. Join Us
Why Not to Hold Strangles Through Earnings
Kim posted a article in Trading BlogAs a reminder, a strangle involves buying calls and puts on the same stock with different strikes. Buying calls and puts with the same strike is called a long straddle. Strangles usually provide better leverage in case the stock moves significantly. So let’s see how it works. First, you must identify stocks which have a history of big post-earnings moves. Some examples include AMZN, Netflix, Google, Priceline (PCLN), and others. Then you buy a strangle or a straddle a day or two before the earnings are announced. If the stock has a big move, you sell for a big profit. The problem is you are not the only one knowing that earnings are coming. Everyone knows that those stocks move a lot after earnings, and everyone bids those options. Following the laws of supply and demand, those options become very expensive before earnings. The IV (Implied Volatility) jumps to the roof. The next day the IV crashes to the normal levels and the options trade much cheaper. Let’s examine a few test cases from the 2011 earnings cycle. AKAM announced earnings on Oct. 26. The $24 straddle could be purchased for $4.08. IV was 84%. The next day the stock jumped 15%, yet the straddle was worth only $3.81. The reason? IV collapsed to 47%. The market “expected” the stock to move 17-18%, based on previous moves, but the stock moved “only” 15% and the straddle lost 7%. BIDU announced earnings on Oct. 26. The stock moved 4.5% following the earnings. You could purchase the straddle at $19.55 the day before earnings. The same straddle was worth $13.47 the next day. That’s a loss of 31%. TIVO moved 2%, the straddle lost 29%. FSLR moved 3%, the straddle lost 55%. Now let’s check a couple of good trades. NFLX announced earnings on October 24. The stock collapsed 34.9% the next day, a move of historical proportions. The 120 strangle could be purchased the day before earnings at $24.52 and sold the next day at $43.00. That’s a 75% gain, but this is as good as it gets. This is a move of historic proportions but the trade is even not a double. AMZN straddle gained 57%. CME straddle gained 62%. GMCR straddle gained 84%. It is easy to get excited after a few trades like NFLX, GMCR, CME and AMZN. However, we have to remember that those stocks experienced much larger moves than their average move in the last few cycles. In some cases, the move was double what was expected. NFLX and GMCR moved more than 35%, the largest moves in at least 10 years. Chances are this is not going to happen every cycle. There is no reliable way to predict those events. The big question is the long term expectancy of the strategy. It is very important to understand that for the strategy to make money it is not enough for the stock to move. It has to move more than the markets expect. In some cases, even a 15-20% move might not be enough to generate a profit. Some people might argue that if the trade is not profitable the same day, you can continue holding or selling only the winning side till the stock moves in the right direction. It can work under certain conditions. For example, if you followed the specific stock in the last few cycles and noticed some patterns, such as the stock continuously moving in the same direction for a few days after beating the estimates. Another example is holding the calls when the general market is in uptrend (or downtrend for the puts). However, it has nothing to do with the original strategy. From the minute you decide to hold that trade, you are no longer using the original strategy. If the stock didn’t move enough to generate a profit, you must be ready to make a judgement call by selling one side and taking a directional bet. This might work for some people, but the pure performance of the strategy can be measured only by looking at a one day change of the strangle or the straddle (buying a day before earnings, selling the next day). The bottom line: Over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move. Jeff Augen, a successful options trader and author of six books, agrees: “There are many examples of extraordinary large earnings-related price spikes that are not reflected in pre-announcement prices. Unfortunately, there is no reliable method for predicting such an event. The opposite case is much more common – pre-earnings option prices tend to exaggerate the risk by anticipating the largest possible spike.” It doesn’t necessarily mean that the strategy cannot work and produce great results. However, in most cases, you should be prepared to hold beyond the earnings day, in which case the performance will be impacted by many other factors, such as your trading skills, general market conditions etc. To hedge your bets and reduce the loss if the stock doesn't move, you might consider trading a Reverse Iron Condor. This article was originally published here. Related articles: How We Trade Straddle Option Strategy Exploiting Earnings Associated Rising Volatility Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? Long Straddle: A Guaranteed Win? Straddle, Strangle Or Reverse Iron Condor (RIC)? How We Made 23% On QIHU Straddle In 4 Hours Why We Sell Our Straddles Before Earnings Selling Strangles Prior To Earnings How To Calculate ROI On Credit Spreads Straddle Option Overview Long Straddle Through Earnings Backtest Straddles - Risks Determine When They Are Best Used The Gut Strangle Long And Short Straddles: Opposite Structures
Studies Vs. Real Trading
Kim posted a article in Trading Blogtastytrade tried to Put The Nail In The Coffin On Buying Premium Prior To Earnings. They did it several times, and we debunked their studies several times. Kirk Du Plessis from OptionAlpha conducted a comprehensive study backtesting different earnings strategies. This is the part that is relevant to our pre earnings straddle strategy: The conclusion is that buying long straddle (or strangle) and closing the day before earnings is a losing proposition. The backtest included different entry days from earnings: 30, 20, 10, 5, or 1 day from the earnings event. Our real life trading results are very different: You can see full statistics here. The question many people ask us: are all those studies wrong? How their results are so different from our real life trading performance? The answer is that the studies are not necessarily wrong. They just have serous limitations, such as: The studies use the whole universe of stocks, while we use only a handful of carefully selected stocks that show good results in backtesting. The studies use certain randomly selected entry dates, while we enter only when appropriate. The studies use EOD (End Of Day) prices while we take advantage of intraday price fluctuations. The studies exit a day before earnings while we manage the trades actively by taking profits when our profit targets are hit. This makes a world of difference. If you are not a member yet, you can join our forum discussions for answers to all your options questions. Here is a classic example how real trading is different from "studies". On March 2 2:30pm we entered CPB straddle: The price was 3.05 or 6.5% RV. When considering a trade, we look at the straddle price as percentage of the stock price. We call it RV (Relative Value). We based our entry on the CPB RV chart: We exited the trade on March 3 10:05am for $3.45 credit, 13.1% gain EOD price on March 2 was 3.40 and EOD price on March 3 was 2.95. The study using EOD prices would show 13.2% LOSS while our real trade was closed for 13.1% GAIN. Two points that contributed to the difference: We have a very strict criteria for entering those trades. In some cases we might wait weeks for the price to come down and meet our criteria. Based on historical RV charts, we would not even be entering this trade at 3.40. On the last day, we did not wait till the EOD and closed the trade in the morning when it reached our profit target. This is just one example how a "study" can show dramatically different results from real trading. On a related note, using a dollar P/L in a study is meaningless - this alone disqualifies the whole study. The only thing that matter is percentage amount. Why? Because in order to get objective results, you need to apply the same dollar allocation to all trades. For example, lets take a look on stocks like AMZN and GM. AMZN straddle can cost around $200 and GM straddle around $2. If AMZN straddle average return was -10% or -$20 and GM average return was +50% or $1, the average return should be reported as +20%. In the study, it would be reported as -$9.5. Don't believe everything you read. Use your common sense and take everything with a grain of salt. I have a great respect for Kirk. He is one of the most honest, professional and hardworking people in our industry, but even the greatest minds sometimes get it wrong. Related articles: How We Trade Straddle Option Strategy Buying Premium Prior To Earnings - Does It Work? Can We Profit From Volatility Expansion Into Earnings? How We Made 23% On QIHU Straddle In 4 Hours Why We Sell Our Straddles Before Earnings
Backtesting Pre Earnings Straddles Using CML TradeMachine
Kim posted a article in Trading BlogWe already debunked some of those "studies" here and here. Today we will debunk another study, and will show how to do it properly. On July 7, 2015, tastytrade conducted a study using AAPL, GMCR, AMZN and TSLA. An ATM straddle was purchased 21 days prior to earnings and closed the day before earnings. A table showed the results. The win rate, total P/L, average P/L per day, biggest win and biggest loss were shown: Their conclusion: Wait... They concluded that buying volatility prior to earnings doesn't work based on 4 stocks? Why those 4 specific stocks? Why 21 days prior to earnings? Our members know that those 4 stocks are among the worst to use for this strategy. They also know that entering 21 days prior to earnings is usually way too early (there are some exceptions). Also, what is a significance of dollar P/L when comparing stocks like AMZN and AAPL? At current prices, AMZN straddle would cost around $8,500 while AAPL straddle around $1,200. Theoretically, if we had a 10% loss on AMZN (-$850) and 50% gain on AAPL ($600), the total P/L would be -$250. But the correct calculation would be total P/L of +40% because we need to give equal dollar weight to all trades. But lets see how changing just one parameter can change the results dramatically. We will be using AAPL as an example. First lets use the study parameter of 21 days. Tap Here to See the back-test Entering 21 days prior to earnings is indeed a losing proposition. But lets change it to 10 days and see what happens: Tap Here to See the back-test Can you see how changing one single parameter changes the results dramatically? I have a feeling that tastytrade knew that 21 days would be not the best time to enter - but using different parameters wouldn't fit their thesis. Now lets test the strategy on some of our favorite stocks. NKE, 14 days and 15% profit target: Tap Here to See the back-test MSFT, 7 days and 15% profit target: Tap Here to See the back-test CSCO, 21 days and 10% profit target: Tap Here to See the back-test IBM, 7 days and 15% profit target: Tap Here to See the back-test ORCL, 14 days and 20% profit target: Tap Here to See the back-test WMT, 7 days and 10% profit target: Tap Here to See the back-test As you can see, different stocks require different timing and different profit targets. Some work better entering 7 days prior to earnings, some might improve performance with an entry as early as 21 days prior to earnings. The bottom line is: you cannot just select random stocks, combine it with random timing and no trade management, and declare that the strategy doesn't work. But if you select the stocks carefully, combine it with the right timing and trade management, it works very well. Here are our results, based on live trades, not skewed "studies": Related Articles: How We Trade Straddle Option Strategy Buying Premium Prior to Earnings Can We Profit From Volatility Expansion into Earnings Long Straddle: A Guaranteed Win? Why We Sell Our Straddles Before Earnings Is 5% A Good Return For Options Trades?
Long straddle: a guaranteed win?
Kim posted a article in Trading BlogFirst of all, as a general comment, there is no such thing as guaranteed returns in the stock market. If there was, everyone who is trading the stock market would be a millionaire. The proposed trade is called a long straddle option. A long straddle option strategy is vega positive, gamma positive and theta negative trade. That means that all other factors equal, the option straddle will lose money every day due to the time decay, and the loss will accelerate as we get closer to expiration. For the straddle to make money, one of the two things (or both) has to happen: 1. The stock has to move (no matter which direction). 2. The IV (Implied Volatility) has to increase. In simple terms, Implied Volatility is the amount of stock price fluctuations. Being on the right side of implied volatility changes can enhance the chances of success. The problem with the proposed setup is that you are not the only one who knows about the event - it’s a public knowledge, so market participants bid the options prices in anticipation of the event, driving IV to higher than usual levels. After the event the IV usually collapses. If the stock moves more than “implied” by the straddle price, then the straddle will be a winner. BUT more often than not, the options prices overprice the potential move, and when the stock moves less than expected, collapsed IV will make the straddle a loser. Example: NFLX was scheduled to report earnings on October 15, 2015. The stock was trading around $110, and 110 straddle around 15.50. This price "implied" $15.50 move. The following image presents the P/L chart of the trade: As we can see, the IV is around 240% for those options, reflecting the upcoming event. Fast forward 24 hours: the stock moved $9 which is a substantial move, but less than "implied" by the options prices. This is the P/L chart: As we can see, IV collapsed to ~85%, and the trade has lost 42%. At SteadyOptions, we trade straddles in a different way. We usually buy a straddle around 7-10 days before the event and sell it 1-2 days before the event when IV peaks. This setup can benefit from the stock moving and/or IV increase. Related articles: How We Trade Straddle Option Strategy Buying Premium Prior to Earnings Can We Profit From Volatility Expansion into Earnings Understanding Implied Volatility How We Made 23% On $QIHU Straddle In 4 Hours Want to learn more? Start Your Free Trial
Can We Profit From Volatility Expansion Into Earnings?
Kim posted a article in Trading BlogThe study was done today - here is the link. The parameters of the study: Use AAPL and GMCR as underlying. Buy a ATM straddle option 20 days before earnings. Sell it just before the announcement. The results of the study, based on 48 cycles (2009-2014) AAPL P/L: -$2933 GMCR P/L: -$2070 Based on those results, they declared (once again) that buying a straddle before earnings is a losing strategy. What's wrong with this study? Dismissing the whole strategy based on two stocks is completely wrong. You could say that this strategy does not work for those two stocks. This would be a correct statement. Indeed, we do not use those two stocks for our straddles strategy. From our experience, entering 20 days before earnings is usually not the best time. On average, the ideal time to enter is around 5-10 days before earnings. This when the stocks experience the largest IV spike. But it is also different from stock to stock. The study does not account for gamma scalping. Which means that if the stock moves, you can adjust the strikes of the straddle or buy/sell stock against it. Many times the stock would move back and forward from the strike, allowing you to adjust several times. In addition, the study is probably based on end of day prices, and from our experience, the end of day price on the last day is usually near the day lows, and you have a chance to sell at higher prices earlier. The study completely ignores the straddle prices. We always look at prices before entering and compare them to previous cycles. Entering the right stocks at the right time at the right prices is what gives this strategy an edge. Not selecting random stocks, random timing and ignoring the prices. As a side note, presenting the results as dollar P/L on one contract trade is meaningless. GMCR is trading around $150 today, and pre-earnings straddle options cost is around $1,500. In 2009, the stock was around $30, and pre-earnings straddle cost was around $500. Would you agree that 10% gain (or loss) on $1,500 trade is different than 10% gain (or loss) on $500 trade? The only thing that matters is percentage P/L, not dollar P/L. Presenting dollar P/L could potentially severely skew the study. For example, what if most of the winners were when the stock was at $30-50 but most of the losers when the stock was around $100-150? Tom Sosnoff and Tony Battista conclude the "study" by saying that "if anybody tells you that you should be buying volatility into earnings, they really haven't done their homework. It really doesn't work". At SteadyOptions, buying pre-earnings straddle options is one of our key strategies. Check out our performance page for full results. As you can see from our results, the strategy works very well for us. We don't do studies, we do live trading, and our results are based on hundreds real trades. Of course the devil is in the details. There are many moving parts to this strategy: When to enter? Which stocks to use? How to manage the position? When to take profits? And much more. So we will let tastytrade to do their "studies", and we will continue trading the strategy and make money from it. After all, as one of our members said, someone has to be on the other side of our trades. Actually, I would like to thank tastytrade for continuing providing us fresh supply of sellers for our strategy! If you want to learn more how to use it (and many other profitable strategies): Start Your Free Trial Related Articles: How We Trade Straddle Option Strategy Long Straddle: A Guaranteed Win? Why We Sell Our Straddles Before Earnings Long Straddle: A Guaranteed Win? How We Made 23% On QIHU Straddle In 4 Hours
Straddle Option Overview
Kim posted a article in Trading BlogThe following infographic gives a brief introduction of a straddle option strategy.
Selling Straddles: Too Risky?
Mark Wolfinger posted a article in Trading BlogThe truth is that selling straddles is a strategy that seeks a high profit and it must come with significant risk. When you are naked short options, loss is theoretically unlimited – and there's nothing to be done about that. Sure, we know there will not be a 50% one-day rally, nor will there be a one-day 75% decline. But they are theoretically possible and that makes it impossible to estimate the maximum loss for the straddle. If willing to live with the risk of a gigantic loss, then you may be comfortable selling straddles. However, because you are asking about risk reduction, I assume that unlimited loss is something you prefer to avoid. Iron Condor vs. Straddle The best (in my opinion) protection is to buy a put that is farther OTM than your short put. In other words, I am willing to pay that very high price for the put because it provides complete protection against a huge gap opening – or any significant move. By 'complete protection' I mean it establishes a maximum possible loss. When you have the ability to set that loss potential, you are in position to trade more effectively. Money management For example, when you recognize the worst possible result, you are better able to size the trade properly. Translation: You can make a very good judgement about how many contracts to trade. When selling straddles, there is no good method to allow effective money management. Note the difference: You can manage risk by adjusting positions as needed – assuming that there is no large market gap. However, there is no way to practice sound money management money when you don't have a good estimate of how much is at risk. Yes, this is very expensive, reduces potential profits significantly and converts the straddle into an iron condor (assuming you do this on both the put and call sides). However, it does allow you to have a better handle on money management and risk management. Alternative: Strangle If you fear, or anticipate a market decline, you can take out partial insurance right now – when initiating the position. There is nothing magical about selling straddles, and you can trade a strangle instead. In this scenario, you would sell the 1185 call, as planned, but could choose a lower strike put. Perhaps the 1165 or the 1150 put? The point is that you build in your market bias by making a small (not 100 points) adjustment in the strike prices of the options sold. Protection I've been trading options since 1975 and have come to one major risk management rule that suits my comfort zone. I no longer sell any naked options (unless I want to buy stock and elect to sell a naked put in an attempt to buy stock at a lower price). I have incurred too many large losses from being short far too many naked options – both calls and puts. I am NOT telling you to adopt that same limitation. What I am doing is asking you to consider the risk of selling straddles and decide if it works for you. It may be a perfect (high risk) strategy for your trading style. a) Buying debit spreads (puts in your example) is far less costly and provides far less protection than buying single options. And that protection is limited. But if there is no huge gap, this is a very useful method to reduce risk. I'd prefer not to constantly use the phrase 'if there is no gap,' but the truth is, that's the big, ugly enemy for the naked call or put seller. That gap eliminates the opportunity to make a timely adjustment before disaster occurs. b) Another risk management method to consider is to reduce the time that you own the short straddle position. True, the most rapid time decay comes near expiration, but if you take the extra risk associated with selling naked options, you can counter some of that risk by not holding into expiration. Consider owning the position for only two or three weeks, taking the profit, and waiting patiently until it's time to open a new straddle. Being out of the market is one sure method for reducing risk. c) Other solutions exist, but buying single options or debit spreads represent the most simple and effective choices. Another example is an OTM put backspread. But please be warned: The risk graph may look very good today and you may feel adequately protected today, but the passage of time turns these into situations in which you may incur a big loss from the original straddle plus another from the back spread. Example Buy some SPX Dec 1120 puts and sell fewer SPX Dec 1130 puts. Because you own extra options, the gigantic downside move will not hurt. However, if SPX declines and moves near 1120 as expiration arrives, this backspread can lose big money. This is not the appropriate time to go into a further description of the backspread, but some of the problems are mentioned in this post. Related articles Trading An Iron Condor: The Basics How To Blow Up Your Account Trader Mindsets The Options Greeks: Is It Greek To You? Want to learn how to trade options in a less risky way? Start Your Free Trial