## THE OPTIONS COURSE- Straddles, Strangles, and Synthetics

THE OPTIONS COURSE

The successful delta neutral trader looks at a market scenario with a discerning eye. Delta neutral trading involves hunting for the optimal mathematical relationship among strikes, premiums, and expiration months. The final strategy creates the highest probability of profitability and enables the trader to enjoy consistent returns on investments. For example, if I’m going to buy stock shares, I’m also going to buy or sell something in the options pit. When I put on one trade, I simultaneously put on another. These kinds of multiple trade strategies require a trader to consider the market from three directions.

1. What if the market goes up?
2. What if it goes down?
3. What if it doesn’t go anywhere at all?

Do not confuse assessing these possibilities with trying to forecast market direction. Delta neutral traders do not need to guess which way the market will move because they have assessed in advance their reactions to market direction. They set up trades that maximize profits and minimize risk by balancing the delta of the overall position—and then they can make money regardless of market direction.

DELTA NEUTRAL MECHANICS

Setting up a delta neutral trade requires selecting a calculated ratio of short and long positions to create an overall position delta of zero. Thus, if you’re buying 100 shares of stock or one futures contract, you are +100 deltas; if you are selling 100 shares of stock or one futures contract, you are –100 deltas. That’s a pretty simple number to work with. It is not an abstract number. It’s +100 or –100, and that’s it.  You can easily do that much in your head once you get the hang of it. No matter what stock or futures contract it is—S&Ps, bonds, currencies, soybeans, IBM, Dell, or Intel—it has a delta of plus or minus 100.

Options deltas are a little more complex. They depend on what kind of option you are trading—at-the-money (ATM), in-the-money (ITM), or out-of-the-money (OTM)—which is determined by the option’s strike price and its relationship to the price of the underlying asset. Let’s develop an example using shares of XYZ currently trading at \$90. XYZ has options at 80, 85, 90, 95, and 100 (each \$5 increment); the 90s are the ATM options. ATM options have deltas of about +50 or –50. Once again, this is a pretty easy calculation.

It could be off a little bit, but plus or minus 50 is the general rule for an ATM option. This also means that there is a 50–50 chance of an ATM option closing in-the-money. It’s similar to a coin flip—it can go either way. Using these values, let’s create a delta neutral trade. If we buy 100 shares of stock, we have +100 deltas. To get to delta neutral, we have to balance out the +100 deltas by finding –100 deltas, perhaps in the form of two short ATM options, which produce the required –100 deltas. This would bring our overall position delta to zero.

However, how do you determine which options equal –50? If you buy an ATM call, do you think you’re +50 or –50? Well, since the purchase of a call is a bullish sign, buying an ATM call has a delta of +50, while the purchase of a put is a bearish strategy with a delta of –50. The plus and minus just mean that you expect the market to move up or down. In the easiest of terms, buying calls creates a positive delta; selling calls creates a negative delta. Buying puts creates a negative delta; selling puts creates a positive delta. These rules govern all delta neutral trading opportunities.

Positive Deltas—                                   Negative Deltas—
Market Expectation Up                       Market Expectation Down

Let’s return to our quest for a delta neutral trade. The easiest trade to make comes in the form of a straddle: the purchase of an ATM call and an ATM put with the same strike and expiration date. The lower breakeven is the point where the trade will start to generate a profit as the stock continues downward; the upper breakeven is the point at which the trade will become profitable as the stock moves upward.The only place where there is a potential problem is when the stock does not move. Thus, the major problem with a straddle is that we are purchasing both options ATM; thus, the entire value of the two premiums is time value.

As time value is not “real” in that there is no inherent value in it, and time value decreases to zero as the option approaches expiration, we have the crux of the problem with a straddle: The stock must move, and move soon, to recover the money that is being lost by the erosion of time in the trade. There are two ways the trade will be profitable. The first is the obvious one of the stock moving significantly, which will increase the value of one option while simultaneously decreasing the value of the other option, although at a slower rate. The other is for both options to increase in value.

The only way both options will increase in value simultaneously is to have the volatility of the options increase. All other variables in the Black-Scholes option pricing model will affect puts and calls in opposite directions. If the volatility of the options increases, then the option premiums will increase, and the possibility of the stock moving will also increase (the basic concept of what volatility is measuring). Thus, if you can find a stock with relatively low volatility that is increasing, the value of the straddle will increase and also the stock will be likely to move either up or down—a double chance for profit.

FIGURE  Risk Graph of a Delta Neutral Straddle (Long 1 Call and Long 1 Put)

To be successful in trading straddles, we need to find a stock whose volatility is low but about to increase as the stock begins to move. This may sound like real guessing at first, but in reality it is not too hard to discover promising candidates. The primary, most reliable reason for an increase in volatility and for the stock price to move is news. News can be anything from court decisions to new product discoveries to accounting irregularities to earnings announcements. Of the various news possibilities, earnings reports are the easiest to predict, and the most common.

Every quarter, each publicly traded company is required by the Securities and Exchange Commission (SEC) to report its earnings. Thus, each publicly traded firm will have four earnings reports each year—four chances for the stock to move unpredictably. Further, each announcement will tend to be made at approximately the same point in each quarter. The natural state of things is for the stock’s price movement, and hence volatility, to be relatively low until some announcement, or the anticipation of an announcement, triggers an upsurge in the volatility.

Between announcements a firm’s volatility tends to be low, and then it will rise as the earnings date approaches, dropping back down after the announcement and subsequent stock movement. Thus, to enter a successful straddle trade, a trader only needs to determine far enough in advance just when the earnings announcement will be made, enter the trade, and then wait for the announcement date. In the normal case, on or about the announcement date the volatility will spike up and the stock will make its move one way or the other.

At that point you exit the trade. What if you went to sleep and waited for the options to expire? Since the trade is really designed to take advantage of a quick uptick in price movement and volatility, it’s doubtful that you would want to stay in the position until expiration. More than likely, you’ll want to exit the trade as soon as the news breaks; that’s when the volatility ticks up and the stock should move. If you wait much longer, volatility will calm back down and the stock may return to its previous price, sucking all of your profits from the trade.

COMBINING STOCK WITH OPTIONS

Now let’s take a look at trading delta neutral by combining stock with options. Let’s say we’ve entered the market with +100 deltas by purchasing 100 shares of stock. To make the overall trade delta neutral, we have two choices using ATM options. We can either buy two ATM puts or sell two ATM calls. The question becomes whether it is better to sell ATM calls or buy ATM puts to get the necessary –100 deltas. When you sell an option, what happens to your account? You receive a credit for the total premiums of the options you sold. In other words, you have put money in your pocket. However, you have also assumed more risk.

As usual, there’s no such thing as a free lunch. Although putting money in your pocket sounds like a good thing, the unlimited risk you have to assume can be a harrowing experience. So far, setting up a delta neutral trade has been quite simple. However, it takes experience and skill to know which strategy has the greater chance of making money. Since delta neutral trades do not rely on market direction, a profit is possible in most cases regardless of whether the market goes up or down. Let’s say we create a delta neutral trade by purchasing 100 shares of stock and buying two ATM put options.

If the market swings up, the shares make money. However, we are out the premium paid on the two long puts. If the market takes a dive, our stock may lose money, but we’ll make a profit on the two puts by using one as protection and making money on the other one. In other words, the deltas of my two puts will increase faster than the delta of the stock. Obviously, a major ingredient to profit making is setting up trades in such a way that your profits outweigh your losses. However, options aren’t always at-the-money.  You can trade a wide variety of options with many different expiration dates.

Many traders get cold feet deciding which options to work with. In general, ATM options are the easiest to work with, but not necessarily the most profitable. How do I determine which options to use? Once again, I need to visually see the profit and loss potentials of each trade by setting up its respective risk profile. So, let’s set up an example of a delta neutral trade that consists of going long 100 shares of XYZ at \$50 and simultaneously buying two long  50 ATM puts at \$5.  This strategy is called a long synthetic straddle and offers risk that is limited to the double premium paid for the ATM puts.

The purchase of 100 shares of stock creates +100 deltas and the purchase of two ATM puts creates –100 deltas. The risk curve visually details the trade’s limited risk and unlimited potential profit in either direction. The risk graph for this trade creates a curve that is U-shaped. This is what an optimal risk curve looks like—one with limited risk and unlimited reward in either direction. In this example, the maximum risk at option expiration is \$1,000: (5 × 2) × 100. You can also create a long synthetic straddle by selling 100 shares of stock and buying 2 ATM calls. This trade has a relatively low margin requirement and moderate risk.

FIGURE  Delta Neutral Long Synthetic Straddle Risk Graph

Its U-shaped curve reflects unlimited profit potential and risk that is limited to the total premium paid or \$1,000: (5 × 2) × 100. Thus, as long as you are buying the options, the strategy is known as a long synthetic straddle. Conversely, you can create a short synthetic straddle by either purchasing 100 shares of stock and selling two ATM calls or selling 100 shares of stock and selling two ATM puts. With this strategy, your profit is limited to the credit received on the short puts and the risk is unlimited in either direction. Thus, the risk curve of a short synthetic straddle looks like an upside-down U. These trades involve shorting options, which can be extremely risky. If the market crashes you stand to lose a great deal of money.

Conversely, if it moves up quickly you will also lose money. I prefer to teach traders to create trades with U-shaped curves, not upside-down U-shaped curves. Although the latter can be profitable, they often require traders to move quickly when things are not working out right. Typically, I favor buying stocks and buying puts. Although all four of these examples are delta neutral trades, I urge you to avoid unlimited risk until you are have developed a strong track record. There are a variety of factors that you need to be familiar with to help you to determine which strategy has the best profit-making potential for a particular market.

Once the underlying instrument moves far enough away from its initial position, you should be able to make money on one of the legs in your trade. Additionally, multiple contract positions enable traders to make positive or negative adjustments depending on how many deltas your overall position has moved and how many contracts make up the trade.Which strategy do I prefer? In general, I prefer lower-risk trades. They are much less stressful. However, before I would place a trade either way, I would set up a risk profile of each possible strategy. This is by far the best way to find an answer to the question of buying versus selling options.

In general, whenever you are buying options as part of a delta neutral trade, you are creating a risk graph with a U-shaped curve; and whenever you are selling options as part of a delta neutral trade, you are creating an upside-down U-shaped curve. I prefer to work with trades with upward U-shaped curves because they feature limited risk—a much safer strategy, especially for beginners. However, as you progress up your own trader’s learning curve, opportunities will present themselves where you may want to take a higher risk in order to receive a potentially higher reward. Remember, every trade is unique.

For many traders, straddles have become a staple trading strategy in today’s unforgiving market conditions. The idea of risking \$500 a week on a position to make \$250 (or a 50 percent return) in three to four weeks definitely works for me. A straddle is an innovative strategy that can truly benefit traders looking for a continuous income stream and it’s probably the easiest of the delta neutral trades to create. A straddle consists of being long one ATM call and long one ATM put, both with the same strike price and expiration date.

By calculating the deltas, you will note that they add up to zero (long ATM call = +50; long ATM put = –50). Thus, the strike prices of the straddle must be purchased at-the-money for the trade to be delta neutral. If the strikes are at anything other than the stock price, then the trade will not be delta neutral; it will have either a negative or a positive delta bias depending on whether the strikes are above or below the stock price. The idea behind the straddle is that as the stock moves upward in price, the long call becomes more valuable.

Although the long put will lose value at the same time, it will not lose value as fast as the call will gain value. In addition, there is a lower limit as to just how much value the put can lose—it can fall only to zero. Thus, as the stock rises in price, the net effect is that the straddle gains in value. Of course, if the stock falls in price, the opposite will happen. The long put will continue to gain in value while the long call will lose value, but only until it reaches zero as well. Thus, if the stock loses value, the total straddle position will gain in value.

Since buying a straddle involves buying both an ATM call and an ATM put (with identical strike prices and expiration months), buying a straddle can be fairly expensive. Your total risk on the position is the cost of the double premiums. For you to gain a profit, the market has to move sufficiently to make up the cost of that double premium. However, at least there are no margin requirements to worry about. To place a long straddle, you need to locate a market with impending high volatility. For example, you might want to buy shares ahead of an earnings report or during a period of low volatility in anticipation of a period of high volatility.

One of the most volatile days of the month for the stock market is the first Friday of each month when the employment report is released. This is the mother of all economic reports and has the ability to move the market in an absolutely psychotic fashion, typically resulting in a highly volatile day. The volatility might even pick up starting on Thursday, so I often place a straddle on the previous Wednesday. One important thing to remember about straddles is that you don’t have to predict market direction. Regardless of whether it moves up or down, you can make some money. The essential factor is volatility.

Two other reports have an effect on market volatility, especially the financial markets: the Consumer Price Index (CPI) and the Producer Price Index (PPI). Unfortunately, these reports do not have a fixed date of release, although they usually come out the week after the employment report (i.e., the second week of the month). You should mark these dates on your calendar as a reminder. Actually, any report can move the market if the information is unexpected regarding housing starts, durable goods, or any of the leading economic indicators. However, the ones to pay particular attention to are the previously mentioned big three.

You may have an opportunity to buy a straddle a couple of days before they are released and make some money. The major disadvantage of a straddle is time decay. There is a substantial time premium to be lost if you do not choose your maturities properly and follow the rules for how long to hold these positions. The other disadvantage to straddles is that if the implied volatility of the options declines (a.k.a. vega risk), you are faced with a substantial penalty because you have had to pay the double premium of the options. That’s why it’s so important to buy cheap (low volatility) options in the first place.

Let’s create a long straddle by going long 1 September XYZ 50 Call @ 2.50 and long 1 September XYZ 50 Put @ 2.50 with XYZ currently trading for \$50 a share. The maximum profit of this trade is unlimited. Both options have the same expiration month and the same strike price. Let’s take a look at a long straddle’s risk profile. To visualize the risk profile of a straddle, it can be helpful to imagine what each leg of the trade looks like. As previously defined, buying a straddle requires the purchase of a call and a put at the same strike price and the same expiration period.

Since risk curves of complex strategies are only combinations of more basic trades, the risk profile of a long straddle is a combination of a long call risk curve and a long put risk curve. When combined, they create a V-shaped curve. This important factor tells us that long straddles have unlimited profit potential and limited risk (the price of the two premiums). When you create a long straddle, it is very important to determine the trade’s range of profitability.

To accomplish this, you need to calculate the upside breakeven and the downside breakeven. The upside breakeven occurs when the underlying asset’s price equals the strike price plus the total premium. In this example, the upside breakeven is 55: 50 + (2.50 + 2.50) = 55. The downside breakeven occurs when the underlying asset’s price equals the strike price minus the total premium. In this case, the downside breakeven equals 45: 50 – (2.50 + 2.50) = 45. XYZ has to move below \$45 or above \$55 for the straddle to make money by expiration.

Exiting the Position

The following exit strategies can be applied to the long straddle example:

• XYZ falls below the downside breakeven (45): You can offset the put by selling a put for a profit. You can hold the essentially worthless call for a possible stock reversal.

• XYZ falls within the downside (45) and upside (55) breakevens: This is the range of risk and will cause you to close out the position at a loss. Simply sell the ATM options to exit the trade. The maximum risk is equal to the double premiums paid out or \$500.

• XYZ rises above the upside breakeven (55): You are in your profit zone again. You can close the call position for a profit and hold the worthless put for a possible stock reversal.

A long straddle is the simultaneous purchase of a call and a put using the same strike and the same expiration month. Since it involves the purchase of a double premium, the cost to enter is often high. This being the case, a long straddle should be used on options that have low implied volatility. When a trader expects a large move in a stock, but isn’t sure about the directional bias of the move, a straddle is a good strategy to employ. A straddle is a limited risk, unlimited reward strategy that relies on a strong move in the underlying security. The maximum risk is the total debit paid to enter the trade.

In order to find the breakeven points, we have to add the debit of the trade onto the strike price for the upside breakeven and subtract it from the strike for the downside breakeven. In order to see how this works, let’s look at a real-life example. At the beginning of 2003, shares of Cisco (CSCO) started to form a chart pattern called a descending triangle. This formation often precedes a major move in a stock, but the direction of the move is hard to determine.  Therefore, an options trader might want to use a straddle to benefit from a move in either direction.

On April 10, 2003, Cisco shares closed at \$13.21 after bouncing from the support. The triangle was becoming smaller, telling us that the stock was about to break out—yet the direction of the break was still hard to determine. Therefore, we entered a straddle. The October 12.50 puts could be purchased for 1.55 a share and the October 12.50 calls could be purchased at 2.25. Buying five contracts would cost \$1,900: [5 × (1.55 + 2.25)] × 100. This is also our maximum risk.

The nice thing about a straddle is that if the stock doesn’t move as expected, the straddle owner can get out without much of a loss as long as the options are not held until expiration. This is because time decay is light when an option is several months away from expiration.(Each line provides an idea of what the trade would be worth given a move within a certain time period; the lowest line shows the trade at expiration.) To calculate the breakevens for this trade, add the net debit per contract of 3.80 to the strike of 12.50 to get an upside breakeven of \$16.30.

FIGURE  Risk Graph of Long Straddle on CSCO

The downside breakeven is found by subtracting 3.80 from the strike of 12.50 to get 8.70. CSCO shares did indeed break out and did so to the upside. On June 19, the daily chart formed a bearish formation and the owner of this straddle might have decided this was the point to exit. CSCO shares closed the session at \$18.56, with the October 12.50 calls worth \$620 a contract. Thus, the value of the five calls was \$3,100. Once we subtract the debit of \$1,900, we have a healthy profit of \$1,200—a return on investment of 63 percent.

Purchasing a straddle allows the trader to make large potential profits if the stock moves far enough in either direction. To profitably implement this selection strategy, we need to discuss the importance of implied and historical volatility, time decay, breakeven points, and upcoming news events. Finally, we will tie all this information together into a high-profit/low-risk straddle selection blueprint.

First, the stock has to have low implied volatility compared to its historical volatility. The assumption here is that more often than not the implied volatility will return to its historical volatility reading. As traders, we always want to stack the probabilities in our favor, and this volatility “rubber band effect” is a terrific way of doing so. When volatility rises while we are in the trade, the value of our position will increase. We also want to see some price consolidation in recent weeks coupled with this low implied volatility.

Second, given that options are wasting assets, it is vital to always account for time decay. In general, you should allow more than 30 days to still be remaining after you plan to close your straddle position. This is due to the fact that time value decay accelerates in the final 30 days before expiration. Following this rule will help you to reduce risk; any losses due to time value decay are limited to very small amounts.

Third, knowing your breakeven points is important so you can properly set profit targets and stop loss levels. Let’s review: To calculate the upside breakeven point, take the strike price and add it to the cost per straddle; to calculate the downside breakeven point, simply subtract the double premium of the options from the strike price. Breakevens are important in all option strategies and they are mentioned here not as a selection criterion, but rather to emphasize their key role in the trademanagement process.

Fourth, for the straddle to be profitable you have to select the right stock. It is absolutely essential that the company have an impending announcement coming within the next month that historically has caused implied volatility to rise in anticipation. The news events could be new product announcements, stock splits, takeovers, key management changes, or the more predictable quarterly earnings announcements. If the news has already come out, then entering a straddle position is very risky due to the likelihood of a drop-off in volatility.

In summary, here is a recap of the four key straddle trade selection rules:

1. Find a stock with low implied volatility that has a tight trading range spanning the past few weeks.
2. Allow at least 30 days to still be remaining after exiting the straddle position. This is usually right after the key announcement has been made.
3. Know your breakeven points and use them to set profit targets and stop-loss levels.
4. Make sure the company is planning a key announcement in the next three to six weeks and that historically the stock has reacted with exaggerated price movement due to speculation of the impending news event.

Hopefully, these straightforward yet powerful screening techniques will help you find some profitable straddle trades. Following these basic straddle selection rules will place the odds of being profitable squarely in the trader’s corner. There are, of course, numerous other straddle selection techniques as well as adjustments that can be made during the trade; and I would encourage all serious traders to learn and explore the wide range of possibilities this innovative strategy offers. Traders can get stock volatility information from numerous resources on the Internet, but for the most comprehensive options data coverage the Optionetics Platinum site is hard to beat.

Although straddles enable traders entering the stock options arena to have the opportunity to make income on a more short-term basis, straddles can be expensive if you are wrong. The key is finding the right market conditions that make straddles more likely to be profitable. In addition to the basic ideas of looking for stocks with consolidation patterns, earnings reports right around the corner, and options that have low implied volatility (i.e., cheap), I have seen some benefit in following and finding specific ADX patterns.

What is the ADX? The Average Directional Movement Index is a momentum indicator—an oscillator developed by Welles Wilder that seeks to measure the strength of a current trend. The key to successful straddles is finding a stock that will make a breakout move. To be successful, we don’t care what direction the stock moves; we just need a solid move. The ADX is another tool to add to your trader’s toolbox in selecting the right stock candidates for straddles. The ADX is derived from two other indicators, also developed by Wilder, called the Positive Directional Indicator (+DI) and the Negative Directional Indicator (–DI).

The ADX fluctuates between 0 and 100, although readings above 60 are rare. Readings below 20 indicate a weak trend often seen as range trading. Readings above 40 indicate a strong directional trend. Though the ADX does not indicate a trend as bullish or bearish, a reading above 40 clearly indicates there is strength in the current trend. In other words, if you find a stock with a high reading, say above 40, this indicates a strong trend but does not identify it as an upward or downward trend. However, by looking at the stock’s chart you can usually easily identify it. For a straddle, I am looking for the weak, nonexistent trend that appears to be ready to move into a directional breakout.

Now doesn’t that sound like a nice straddle opportunity? So, we can use the ADX to identify potential changes in a stock from nontrending to trending. How is this task accomplished? A good gauge occurs when the ADX begins to strengthen by rising from below 20 to above 20. Based on what I have seen, it is a sign that the range trading is ending and a trend could be developing—be it upward or downward. This kind of scenario is a perfect straddle candidate. The ADX can also indicate that a strong trend is ending and it’s time to take your profits.

If you combine this process with looking for consolidation patterns, earnings reports within four to eight weeks, and cheap options, you are raising the odds in your favor. Over the years, I have become a strong technical analysis advocate. It has increased my odds tremendously. As a person becomes more committed to the idea of trading successfully, finding the right combination of trading tools is vital to your success. Be it fundamental or technical analysis or a combination of both, you need the right tools for your trading style to better gauge market opportunities.

Figure shows a chart of the Oil Service HOLDRS (OIH) along with the 14-day ADX as well as two directional lines, +DI and –DI. When used together, these three lines are part of the Directional Moving Index (DMI) trading system. Basically, traders will be watching the ADX line to see if it is high or low. Standard use of the ADX includes the idea that an ADX line rising above 20 signals a trending market, while an ADX line falling below 40 signals the start of a nontrending environment.

On the chart, we can see ADX rising in November 2003 and crossing above 20 and both directional lines. This signals that a period of quiet trading is ending and the OIH is ready to see a period of greater volatility. The rising ADX served as an alert that a new trend was on the way. In this case, a straddle makes sense. The OIH has been trading quietly, but a volatile move is expected. This is an ideal environment for placing a straddle. Then when ADX rose to high levels and began falling in March 2004, that signaled that the trend in the OIH was reaching an end. At that time, the strategist would want to close the straddle.

The ADX is available in several software packages including Advanced GET and Profit Source, which allow you to set search parameters to produce a list of stocks that meet the requirement of crossing over an ADX of 20. With this list, you can look through the other criteria to find a strong candidate and increase your odds for placing a successful straddle. Given the current market uncertainty, a straddle is an ideal trading strategy to deploy. Here’s hoping that all your straddle trades encounter the most tumultuous of news events.

FIGURE  OIH Price Chart with ADX Line
Share: