price pattern.
■
Try to concentrate on stocks with news events and earnings reports aboutto happen within two weeks.
■
Choose a stock price range you feel comfortable with. For some traders,that’s between $20.00 and $60.00.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Exit either a few days after the news event occurs where there is no movement, or after the news event where there has been profitable movement.
■
If the stock thrusts up, sell the call (making a profit for the entire position)and wait for a retracement to profit from the put.
■
If the stock thrusts down, sell the put (making a profit for the entire position) and wait for a retracement to profit from the call.
■
Try to avoid holding into the last month; otherwise, you’ll be exposed toserious time decay.
4.1.2 ContextOutlook■
With straddles, your outlook is direction neutral. You are looking for increasing volatility with the stock price moving explosively in either direction.
Rationale■
To execute a neutral trade for a capital gain while expecting a surge in volatility. Ideally you are looking for a scenario where Implied Volatility is currentlyvery low, giving you low option prices, but the stock is about to make anexplosive move—you just don’t know which direction.
Net Position■
This is a net debit transaction because you have bought calls and puts.
■
Your maximum risk on the trade itself is limited to the net debit of the boughtcalls and puts. Your maximum reward is potentially unlimited.
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Effect of Time Decay■
Time decay is harmful to the Straddle. Never keep a Straddle into thelast month to expiration because this is when time decay accelerates thefastest.
Appropriate Time Period to Trade■
We want to combine safety with prudence on cost. Therefore the optimum timeperiod to trade straddles is with three months until expiration, but if the stockhas not moved decisively, sell your position when there is one month to expiration. Be wary of holding a Straddle into the last month.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Actively seek chart patterns that appear like pennant formations, signifying aconsolidating price pattern that may be about to explode.
■
Try to concentrate on stocks with news events and earnings reports about tohappen within two weeks.
■
Choose a stock price range you feel comfortable with.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—ATM for the put and call.
■
Expiration—Preferably around three months. Use the same expiration date forboth legs.
4.1.3 Risk Profile■
Maximum Risk
[Net debit paid]
■
Maximum Reward
[Uncapped]
■
Breakeven Down
[Strike  net debit]
■
Breakeven Up
[Strike  net debit]
Volatility Strategies
4.1.4 GreeksKey:ExpirationToday – 3 monthsTime(t) – 1 monthRisk ProfileIf the stock priceremains around thestrike price, we makeour maximum loss. Ifit moves explosivelyin either direction, wemake profits.DeltaDelta (speed) is at itsgreatest when theposition is makingmoney in either direction. The negativeDelta is purely an indication of direction;i.e., making profit asthe stock falls.
Risk Profile
Theta
ThetaTime decay is mostharmful when theposition is unprofitable.
Delta
Vega
VegaVolatility is helpful tothe position particularly at the strikeprice where the stockhasn’t yet moved.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position whenthe stock rises andvice versa.
GammaGamma (acceleration)peaks around thestrike price, illustrating the position’sturning point and thefastest rate of change.
4.1.5 Advantages and DisadvantagesAdvantages■
Profit from a volatile stock moving in either direction.
■
Capped risk.
■
Uncapped profit potential if the stock moves.
Disadvantages■
Expensive—you have to buy the ATM call and put.
■
Significant movement of the stock and option prices is required to make aprofit.
■
Bid/Ask Spread can adversely affect the quality of the trade.
■
Psychologically demanding strategy.
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4.1.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by selling your calls andputs.
■
You can also exit only your profitable leg of the trade and hope that the stockretraces to favor the unprofitable side later on. For example, if the share hasmoved decisively upwards, thus making the call profitable, you will sell thecalls and make a profit on the entire trade, but you will be left with almostvalueless puts. Having now sold the calls, you will hope that the stock mayretrace and enhance the value of the puts you are still holding, which you canthen sell.
Mitigating a Loss■
Sell the position if you have only one month left to expiration. Do not hold on,hoping for the best, because you risk losing your entire stake.
4.1.7 ExampleABCD is trading at $25.37 on May 17, 2004.Buy the August 2004 25 strike put for $1.70.Buy the August 2004 25 strike call for $2.40.Net Debit
Premiums bought$1.70  $2.40  $4.10
Maximum Risk
Net debit$4.10
Maximum Reward
Uncapped
Breakeven Down
Strike  net debit$25.00  $4.10  $20.90
Breakeven Up
Strike  net debit$25.00  $4.10  $29.10
So we can see that if we held on to expiration, our breakevens would be $20.90 and$29.10, respectively. In other words, the stock would have to fall to below $20.90 orrise above $29.10 in order for us to make a profit. In reality we don’t hold on untilexpiration, and therefore, because both options will still contain some time valuebefore that final month, our breakevens will be slightly more narrow, which ofcourse helps us.In the previous example, we haven’t taken into account the rules, but let’s assumethat there was an earnings announcement on, say, May 21. Let’s also assume that thethree-month high had been $26.49 and the three-month low had been $16.39. The
Volatility Strategies
difference between the two is $10.10. Divide in half to get $5.05, which is greater thanour Straddle cost of $4.10. Therefore we passed the rules, assuming of course that thechart pattern was acceptable!
4.2 StrangleProficiency
Direction
Volatility
Asset Legs
Intermediate
Neutral
High
■ Long Put
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
Capped
■ Long Call
4.2.1 DescriptionThe Strangle is a simple adjustment to the Straddle to make it slightly cheaper.Instead of buying ATM options, we buy OTM calls and puts, which creates a lowercost basis and therefore potentially higher returns. The risk we run with a Strangleis that the breakevens can be pushed further apart, which is bad, but where thedifference is not too great (and that’s a judgment call), then the Strangle can bespectacular.The Strangle is the second easiest volatility strategy to understand, and we onlylook at it if the Straddle criteria have been obeyed. We simply buy lower strike putsand higher strike calls with the same expiration date so that we can profit from thestock soaring up or plummeting down. As with the Straddle, each leg of the tradehas limited downside (i.e., the call or put premium) but uncapped upside.Again the same challenges apply regarding Bid/Ask Spreads and the psychologyof the actual trade. Remember that time decay hurts long options positions becauseoptions are like wasting assets. The closer we get to expiration, the less time valuethere is in the option. Time decay accelerates exponentially during the last monthbefore expiration, so we don’t want to hold onto OTM or ATM options into the lastmonth.Use the Straddle rules but then make an adjustment for the Strangle:1. Instead of trading the ATM calls and puts, choose the next strike lower for theput and the next strike higher for the call.2. Now compare the breakeven scenarios for the Strangle to those for theStraddle. Typically the Strangle’s breakevens will be slightly wider. Now youmust make a judgment between the cost of the Strangle and the likelihood ofthe stock moving explosively up or down. Because the rules have alreadypassed, you should have established a good likelihood of a move happening.Again, it’s important to follow the entry and exit rules, and psychologically speaking, it’s another tough strategy to play after you’re in. It’s very easy to find reasonsto exit, even though it’s in breach of your trading plan. But you must remember that
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you got in for a certain reason (or reasons), and you must stay in until one of yourother reasons compels you to exit.
Buy OTM put
Buy OTM call
Strangle
Steps to Trading a Strangle1. Buy OTM (lower) strike puts, preferably with about three months to expiration.2. Buy OTM (higher) strike calls with the same expiration.Steps In■
Actively seek chart patterns that appear like pennant formations, signifyinga consolidating price pattern.
■
Try to concentrate on stocks with news events and earnings reports aboutto happen within two weeks.
■
Choose a stock price range you feel comfortable with. For some traders,that’s between $20.00 and $60.00.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Exit either a few days after the news event occurs where there is no movement or after the news event where there has been profitable movement.
■
If the stock thrusts up, sell the call (making a profit for the entire position)and wait for a retracement to profit from the put.
■
If the stock thrusts down, sell the put (making a profit for the entire position) and wait for a retracement to profit from the call.
■
Try to avoid holding into the last month; otherwise, you’ll be exposed toserious time decay.
4.2.2 ContextOutlook■
With strangles, your outlook is direction neutral. You are looking for increasing volatility with the stock price moving explosively in either direction.
Rationale■
To execute a neutral trade for a capital gain while expecting a surge in volatility. Ideally you are looking for a scenario where Implied Volatility is currentlyvery low, giving you low option prices, but the stock is about to make anexplosive move—you just don’t know which direction.
Volatility Strategies■
Strangles are cheaper than Straddles because you are buying OTM options onboth sides, as opposed to buying ATM options. This can also have the effect ofwidening your breakeven points.
Net Position■
This is a net debit transaction because you have bought calls and puts.
■
Your maximum risk on the trade itself is limited to the net debit of the boughtcalls and puts. Your maximum reward is potentially unlimited.
Effect of Time Decay■
Time decay is harmful to the Strangle. Never keep a Strangle into the lastmonth to expiration because this is the time when time decay accelerates thefastest.
Appropriate Time Period to Trade■
We want to combine safety with prudence on cost. Therefore, the optimumtime period to trade Strangles is with three months until expiration, but if thestock has not moved decisively, sell your position when there is one month toexpiration. Be wary of holding a Strangle into the last month.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Actively seek chart patterns that appear like pennant formations, signifying aconsolidating price pattern that may be about to explode.
■
Try to concentrate on stocks with news events and earnings reports about tohappen within two weeks.
■
Choose a stock price range you feel comfortable with.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Put Strike—Below the current stock price.
■
Call Strike—Above the current stock price.
■
Expiration—Preferably around three months. Use the same expiration date forboth legs.
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4.2.3 Risk Profile■
Maximum Risk
[Net debit paid]
■
Maximum Reward
[Uncapped]
■
Breakeven Down
[Lower strike  net debit]
■
Breakeven Up
[Higher strike  net debit]
4.2.4 GreeksKey:ExpirationToday – 3 monthsTime(t) – 1 monthRisk ProfileIf the stock priceremains between thestrike prices, we makeour maximum loss. Ifit moves explosivelyin either direction, wemake profits.
Risk Profile
Theta
ThetaTime decay ismost harmful whenthe position isunprofitable.
DeltaDelta (speed) is at itsgreatest when theposition is makingmoney in either direction. The negativeDelta is purely an indication of direction;i.e., making profit asthe stock falls.
Delta
Vega
VegaVolatility is helpful tothe position, particularly between thestrike prices.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position whenthe stock rises andvice versa.
GammaGamma (acceleration)peaks between thestrike prices, illustrating the position’sturning point and thefastest rate of change.
4.2.5 Advantages and DisadvantagesAdvantages■
Profit from a volatile stock moving in either direction.
■
Capped risk.
■
Uncapped profit potential if the stock moves.
■
Cheaper than a Straddle.
Volatility Strategies
Disadvantages■
Significant movement of the stock and option prices is required to make a profit.
■
Bid/Ask Spread can adversely affect the quality of the trade.
■
Psychologically demanding strategy.
4.2.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by selling your calls andputs.
■
You can also exit only your profitable leg of the trade and hope that the stockretraces to favor the unprofitable side later on. For example, if the share hasmoved decisively upwards, thus making the call profitable, you will sell thecalls and make a profit on the entire trade, but you will be left with almostvalueless puts. Having now sold the calls, you will hope that the stock mayretrace and enhance the value of the puts you are still holding, which you canthen sell.
Mitigating a Loss■
Sell the position if you have only one month left to expiration. Do not hold on,hoping for the best, because you risk losing your entire stake.
4.2.7 ExampleABCD is trading at $25.37 on May 17, 2004.Buy the August 2004 $22.50 strike put for $0.85.Buy the August 2004 $27.50 strike call for $1.40.Net Debit
Premiums bought$0.85  $1.40  $2.25
Maximum Risk
Net debit$2.25
Maximum Reward
Uncapped
Breakeven Down
Lower strike  net debit$22.50  $2.25  $20.25
Breakeven Up
Higher strike  net debit$27.50  $2.25  $29.75
Let’s compare this trade to the Straddle in the previous section. The main differencesin results are that the net debit is less and the breakevens are about $0.65 wider atexpiration. The question is . . . would we prefer the Straddle or the Strangle?
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This is a judgment call based on the potential movement of the stock, coupledwith your experience and the news event you’re anticipating. In this case, with noother information other than that the Straddle passed the rules, I’d be tempted!
4.3 StripProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
Expert
Bearish
High
■ Two Long Puts
Capped
■ One Long Call
4.3.1 DescriptionThe Strip is a simple adjustment to the Straddle to make it more biased toward thedownside. In buying a second put, the strategy retains its preference for high volatility but now with a more bearish slant.As with the Straddle, we choose the ATM strike for both legs, which means thestrategy is expensive. We’re therefore requiring a pretty big move, preferably withthe stock plunging downwards. As such, our risk is greater than with the Straddle,and our reward is still uncapped. Because we bought double the number of puts,our position improves at double the speed, so the breakeven to the downside isslightly tighter. The breakeven to the upside is the strike plus the net debit, which ismore than the Straddle because we’ve bought double the amount of puts.Again the same challenges apply regarding Bid/Ask Spreads and the psychologyof the actual trade. Remember that time decay hurts long options positions becauseoptions are like wasting assets. The closer we get to expiration, the less time value thereis in the option. Time decay accelerates exponentially during the last month beforeexpiration, so we don’t want to hold onto OTM or ATM options into the last month.Use the Straddle rules but buy twice as many puts as calls in order to make anadjustment for the Strip.Again, it’s important to follow the entry and exit rules (as for straddles), and psychologically speaking, this is another tough strategy to play after you’re in. It’s veryeasy to find reasons to exit, even though it’s in breach of your trading plan. But youmust remember that you got in for a certain reason (or reasons), and you must stayin until one of your other reasons compels you to exit.Here’s a reminder of the rules for trading straddles that you must also apply tostrips:1. Choose your preferred stock price range. Some traders choose stocks between$20.00 and $60.00, but that’s a personal preference.2. Only do a Strip on a stock that is close to making an announcement that maycause a surprise jump in the stock price either way, such as the week before anearnings report.
Volatility Strategies
3. Buy ATM calls and puts with the expiration at least two months away, preferably three. You can get away with four months if nothing else is available.4. The cost of the Straddle should be less than half of the stock’s recent high lessits recent low. By recent, we mean the last 40 trading days for a two-monthStraddle, the last 60 trading days for a three-month Straddle, or the last 80 daysfor a four-month Straddle. The point here is that the cost of the Straddle shouldbe low in comparison with the potential of the stock to move. If this workswith the Straddle, then the Strip can be acceptable.5. Exit within two weeks after the news event occurs. Never hold into the finalmonth before expiration. During the final month, your options will sufferincreasing time decay, which we don’t want to be exposed to.6. Try to find a stock that is forming a consolidation pattern, such as a flag orpennant, or in other words, where the stock price action has become tighterand where volatility has shrunk in advance of a big move in either direction.Typically we’re looking for a pennant within the context of a downward trend.
Buy two ATM puts
Buy ATM call
Strip
Steps to Trading a Strip1. Buy two ATM strike puts, preferably with about three months to expiration.2. Buy one ATM strike call with the same expiration.Keep the ratio as two puts for one call.Steps In■
Actively seek chart patterns that appear like pennant formations, signifyinga consolidating price pattern.
■
Try to concentrate on stocks with news events and earnings reports aboutto happen within two weeks.
■
Choose a stock price range you feel comfortable with. For some traders,that’s between $20.00 and $60.00.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Exit either a few days after the news event occurs where there is no movement, or after the news event where there has been profitable movement.
■
If the stock thrusts up, sell the call (making a profit for the entire position)and wait for a retracement to profit from the puts.
■
If the stock thrusts down, sell the puts (making a profit for the entire position) and wait for a retracement to profit from the call.
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Try to avoid holding into the last month; otherwise, you’ll be exposed toserious time decay.
4.3.2 ContextOutlook■
With strips, your outlook is neutral to bearish. You are looking for increasingvolatility with the stock price moving explosively in either direction, preferably to the downside.
Rationale■
To execute a neutral to bearish trade for a capital gain while expecting a surgein volatility to the downside. Ideally you are looking for a scenario whereImplied Volatility is currently very low, giving you low option prices, but thestock is about to make an explosive move—you don’t know which direction,but you have a bias toward the downside.
Net Position■
This is a net debit transaction because you have bought calls and puts.
■
Your maximum risk on the trade itself is limited to the net debit of the boughtcalls and puts. Your maximum reward is potentially unlimited.
Effect of Time Decay■
Time decay is harmful to the Strip. Never keep a Strip into the last month toexpiration because this is when time decay accelerates the fastest.
Appropriate Time Period to Trade■
We want to combine safety with prudence on cost. Therefore, the optimumtime period to trade strips is with three months until expiration, but if thestock has not moved decisively, sell your position when there is one month toexpiration. Be wary of holding a Strip into the last month.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Actively seek chart patterns that appear like pennant formations, signifying aconsolidating price pattern, preferably within a downward trend.
■
Try to concentrate on stocks with news events and earnings reports about tohappen within two weeks.
■
Choose a stock price range you feel comfortable with.
Volatility Strategies
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—ATM for the puts and call.
■
Expiration—Preferably around three months. Use the same expiration date forboth legs.
4.3.3 Risk Profile■
Maximum Risk
[Net debit paid]
■
Maximum Reward
[Uncapped]
■
Breakeven Down
[Strike  half the net debit]
■
Breakeven Up
[Strike  net debit]
4.3.4 Greeks
Risk ProfileIf the stock priceremains around thestrike price, we makeour maximum loss. Ifit moves explosivelyin either direction, wemake profits, particularly if the stockmoves down.DeltaDelta (speed) is at itsgreatest when theposition is makingmoney in either direction. The negativeDelta is purely an indication of direction;i.e., making profit asthe stock falls.GammaGamma (acceleration)peaks around thestrike price, illustrating the position’sturning point and thefastest rate of change.
Key:ExpirationToday – 3 monthsTime(t) – 1 monthRisk Profile
Theta
ThetaTime decay is mostharmful when theposition is unprofitable.
Delta
Vega
VegaVolatility is helpful tothe position, particularly at the strikeprice where the stockhasn’t yet moved.
Gamma
Rho
RhoHigher interest ratesare generally unhelpful to the positionwhen the stock fallsand vice versa.
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4.3.5 Advantages and DisadvantagesAdvantages■
Profit from a volatile stock moving in either direction.
■
Capped risk.
■
Uncapped profit potential if the stock moves.
Disadvantages■
Expensive—you have to buy the ATM call and puts.
■
Significant movement of the stock and option prices is required to make aprofit.
■
Bid/Ask Spread can adversely affect the quality of the trade.
■
Psychologically demanding strategy.
4.3.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by selling your calls andputs.
■
You can also exit only your profitable side of the trade and hope that the stockmoves to favor the unprofitable side later on. For example, if the share hasmoved decisively downwards, thus making the puts profitable, you will sellthe puts and make a profit on the entire trade, but you will be left with almostvalueless calls. Having now sold the puts, you will hope that the stock mayretrace upwards and enhance the value of the calls you are still holding, whichyou can then sell.
Mitigating a Loss■
Sell the position if you have only one month left to expiration. Do not hold on,hoping for the best, because you risk losing your entire stake.
4.3.7 ExampleABCD is trading at $25.37 on May 17, 2004.Buy two August 2004 25 strike puts at $1.70.Buy the August 2004 25 strike call for $2.40.
Volatility Strategies
Net Debit
Premiums bought$3.40  $2.40  $5.80
Maximum Risk
Net debit$5.80
Maximum Reward
Uncapped
Breakeven Down
Strike  (net debit / 2)$25.00  $2.90  $22.10
Breakeven Up
Strike  net debit$25.00  $5.80  $30.80
We can see that if we held on to expiration, our breakevens would be $22.10 and$30.80, respectively. In other words, the stock would have to fall to below $22.10 orrise above $30.80 in order for us to make a profit. In reality, we don’t hold on untilexpiration, and therefore because both options will still contain some time valuebefore that final month, our breakevens will be slightly more narrow, which ofcourse helps us.In the previous example, we’ve assumed that the rules required to make aStraddle have been passed in order for us to contemplate the Strip!
4.4 StrapProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
Expert
Bullish
High
■ One Long Put
Capped
■ Two Long Calls
4.4.1 DescriptionThe Strap is a simple adjustment to the Straddle to make it more biased to theupside. In buying a second call, the strategy retains its preference for high volatilitybut now with a more bullish slant.As with the Straddle, we choose the ATM strike for both legs, which means thestrategy is expensive. We’re therefore requiring a pretty big move, preferably withthe stock soaring upwards. As such, our risk is greater than with the Straddle, andour reward is still uncapped. Because we bought double the number of calls, ourposition improves at double the speed, so the breakeven to the upside is slightlytighter. The breakeven to the downside is the strike less the net debit, which is morethan the Straddle because we’ve bought double the amount of calls.Again the same challenges apply regarding Bid/Ask Spreads and the psychologyof the actual trade. Remember that time decay hurts long options positions because
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options are like wasting assets. The closer we get to expiration, the less time valuethere is in the option. Time decay accelerates exponentially during the last monthbefore expiration, so we don’t want to hold onto OTM or ATM options into the lastmonth.Use the Straddle rules but buy twice as many calls as puts in order to make anadjustment for the Strap.Again, it’s important to follow the entry and exit rules (as for straddles), and psychologically speaking, it’s another tough strategy to play after you’re in. It’s veryeasy to find reasons to exit, even though it’s in breach of your trading plan. But youmust remember that you got in for a certain reason (or reasons), and you must stayin until one of your other reasons compels you to exit.Here’s a reminder of the rules for trading straddles that you must also apply forstraps:1. Choose your preferred stock price range. Some traders choose stocks between$20.00 and $60.00, but that’s a personal preference.2. Only do a Strap on a stock that is close to making an announcement, such asthe week before an earnings report.3. Buy ATM calls and puts with the expiration at least two months away, preferably three. You can get away with four months if nothing else is available.4. The cost of the Straddle should be less than half of the stock’s recent high lessits recent low. By recent, we mean the last 40 trading days for a two-monthStraddle, the last 60 trading days for a three-month Straddle, or the last80 days for a four-month Straddle. The point here is that the cost of theStraddle should be low in comparison with the potential of the stock tomove. If this works with the Straddle, then the Strap can be acceptable.5. Exit within two weeks after the news event occurs. Never hold into the finalmonth before expiration. During the final month, your options will sufferincreasing time decay, which we don’t want to be exposed to.6. Try to find a stock that is forming a consolidation pattern, such as a flag orpennant, or in other words where the stock price action has become tighterand where volatility has shrunk in advance of a big move in eitherdirection. Typically we’re looking for a pennant within the context of anupward trend.
Buy ATM put
Buy two ATM calls
Strap
Steps to Trading a Strap1. Buy one ATM strike put with the same expiration.2. Buy two ATM strike calls, preferably with about three months to expiration.
Volatility Strategies
Keep the ratio as two calls for one put.Steps In■
Actively seek chart patterns that appear like pennant formations, signifyinga consolidating price pattern.
■
Try to concentrate on stocks with news events and earnings reports aboutto happen within two weeks.
■
Choose a stock price range you feel comfortable with. For some traders,that’s between $20.00 and $60.00.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Exit either a few days after the news event occurs where there is no movement, or after the news event where there has been profitable movement.
■
If the stock thrusts up, sell the calls (making a profit for