|
Puts and Calls and a little bit
about Covered Calls. Now we're going to start thinking about different
types of spread strategies. Why do we want to spread? Several reasons;
it reduces the overall cost and limits the risk of a position. At the
same time it lowers the breakeven point for the position and allows
flexibility to take advantage of different types of market conditions.
Of course, like everything else in trading, there is a trade-off. The
maximum potential on the upside may be capped, and there will be more
commission costs and more bid/ask spreads to contend with.
Today we're going to examine some characteristics of a very popular
option trading strategy known as a Straddle. First we need to know
exactly what a Straddle is.
Definition: A long (short) Straddle is the purchase (sale) of a Put and a
Call on the same underlying stock with the same strike price and time
to expiration.
Just as a point of information; some traders don't consider a Straddle
to be a spread. They define a spread to be a position that consists of
both long and short options. For our purposes, a spread will be any
position that has both long and short deltas.
An example of a long Straddle would be the purchase of the XYZ July 50
Call and the July 50 Put. If the Call is trading for $2, the Put for
$1.75 and we bought 10 Straddles, the total cost (excluding
commissions) would be $3,750. Of course, if we sold the Straddles, we
would receive a credit of $3,750 coming into our account. Long
Straddles must be paid for in full, they cannot be bought on margin
and short Straddles have margin requirements (that will be the subject
of a future article.).
The following graphs show the profit and loss for both a long and
short Straddle at expiration. Notice, that as you would expect, they
are mirror images of each other. If one side makes money, the other
side loses the same amount. Remember folks, it's a zero sum game.
DELTA and GAMMA - Assuming that the Straddle was put on with the stock
price close to the strike price, the delta will be close to 0,
approximately +50 for the Call and -50 for the Put. That means that
the position doesn't have a bias to either the upside or the downside.
However, since the position is long the Call and the Put, and since
both Calls and Puts have positive Gamma, the Straddle is very long
Gamma. This means that as the stock starts moving away from the
strike, it will get shorter on the downside and longer on the upside.
That's exactly what we want!
We want the stock to move as far as possible from the strike price. In
fact, we can see from the graph that the worst place that the stock
could be at expiration would be at $50. In that case the Straddle
would be worth 0, and we would lose the entire investment of $3,750.
In reality, we would have either exited the position prior to
expiration or made adjustments along the way, and most probably would
not have lost the entire amount. That process will be discussed in a
future article.
It's also always useful to know the breakeven points on the upside and
downside. Fortunately, in the case of a Straddle it's easy to
calculate. Simply add the premium to the strike price to get the
upside breakeven of $50 + 3.75 = $53.75, and subtract the premium from
the strike price to get the downside breakeven of $50 - 3.75 = $
46.25.
VEGA - Again, since the position is long options and long options have
positive vega, this position is very sensitive to changes in
volatility. So in addition to price movement, we are hoping for an
increase in volatility. Well, that implies that we would put this
position on in a low volatility environment. Isn't that a
contradiction? We want low volatility, but large movement in the
stock! Yes and no; at expiration the volatility doesn't matter
anymore. The stock price will be whatever it is, and that will
determine the amount of profit or loss for the position. Prior to
expiration, the volatility can have a great impact on the value of the
Straddle. It is possible that with only a small movement in the stock,
but with a significant increase in implied volatility, that the
Straddle could still be profitable prior to expiration. Sometimes we
can have our cake and eat it too!
THETA - Again, we're still dealing with only long options, and long
options have negative theta, so the position is losing value every
day. Making matters worse, the rate of loss is constantly
accelerating. So what can we do to mitigate this situation? We
generally don't buy near term Straddles. A rule of thumb is that
Straddle buys should be 3 months or more to expiration. I said
"generally" for a reason. There are some situations where it does make
sense to buy near term Straddles, and in fact, one of my favorite
types of trades has to do with buying Straddles on the day of, or day
before, expiration.
The black lines represent the Straddle positions. The
purple and yellow lines represent the expiration graphs of the Call
and Put, respectively. |
