 to  get  an  upside  breakeven  of  $16.30.The downside breakeven is found by subtracting 3.80 from the strike of12.50 to get 8.70.
Long Straddle Case Study
Strategy: With CSCO at $13.04 a share on April 10, Long 5 October 12.50CSCO Puts @ 1.55 and Long 5 October CSCO 12.50 Calls @ 2.25.
Market Opportunity: Expect a breakout from consolidation.
Maximum Risk: Limited to initial debit. In this case, the maximum risk is$1,900: [5 × (1.55 + 2.25)] × 100.
Maximum  Proﬁt: Unlimited  to  the  upside  and  limited  to  the  downside(the underlying asset can only fall to zero). In this case, the trade garnereda proﬁt of $1,200 on June 19.
Downside  Breakeven: ATM  strike  price  minus  the  initial  cost  per  con-tract. In this case, the downside breakeven is 8.70: (12.50 – 3.80).
Upside Breakeven: ATM strike price plus the initial cost per contract. Inthis case, the upside breakeven is 16.30: (12.50 + 3.80).
Margin: None.
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FIGURE 8.4 Risk Graph of Long Straddle on CSCO (Source: OptioneticsPlatinum © 2004)
CSCO shares did indeed break out and did so to the upside. On June19, the daily chart formed a bearish formation and the owner of this strad-dle might have decided this was the point to exit. CSCO shares closed thesession 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.
Proﬁtable Straddle Selection Tactics
Purchasing a straddle allows the trader to make large potential proﬁts ifthe  stock  moves  far  enough  in  either  direction.  To  proﬁtably  implement
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this selection strategy, we need to discuss the importance of implied andhistorical  volatility,  time  decay,  breakeven  points,  and  upcoming  newsevents.  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 his-torical volatility. The assumption here is that more often than not the im-plied volatility will return to its historical volatility reading. As traders, wealways want to stack the probabilities in our favor, and this volatility “rub-ber band effect” is a terriﬁc way of doing so. When volatility rises whilewe are in the trade, the value of our position will increase. We also want tosee some price consolidation in recent weeks coupled with this low im-plied volatility.
Second, given that options are wasting assets, it is vital to always ac-count for time decay. In general, you should allow more than 30 days tostill  be  remaining  after  you  plan  to  close  your  straddle  position.  This  isdue to the fact that time value decay accelerates in the ﬁnal 30 days beforeexpiration. Following this rule will help you to reduce risk; any losses dueto time value decay are limited to very small amounts.
Third, knowing your breakeven points is important so you can prop-erly set proﬁt targets and stop loss levels. Let’s review: To calculate theupside breakeven point, take the strike price and add it to the cost perstraddle; to calculate the downside breakeven point, simply subtract thedouble premium of the options from the strike price. Breakevens are im-portant in all option strategies and they are mentioned here not as a se-lection  criterion,  but  rather  to  emphasize  their  key  role  in  the  trademanagement process.
Fourth,  for  the  straddle  to  be  proﬁtable  you  have  to  select  the  rightstock. It is absolutely essential that the company have an impending an-nouncement  coming  within  the  next  month  that  historically  has  causedimplied  volatility  to  rise  in  anticipation.  The  news  events  could  be  newproduct  announcements,  stock  splits,  takeovers,  key  managementchanges,  or  the  more  predictable  quarterly  earnings  announcements.  Ifthe news has already come out, then entering a straddle position is veryrisky 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 straddleposition.  This  is  usually  right  after  the  key  announcement  has  beenmade.
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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 nextthree  to  six  weeks  and  that  historically  the  stock  has  reacted  withexaggerated  price  movement  due  to  speculation  of  the  impendingnews event.
Hopefully,  these  straightforward  yet  powerful  screening  techniqueswill help you ﬁnd some proﬁtable straddle trades. Following these basicstraddle selection rules will place the odds of being proﬁtable squarely inthe trader’s corner. There are, of course, numerous other straddle selec-tion techniques as well as adjustments that can be made during the trade;and I would encourage all serious traders to learn and explore the widerange of possibilities this innovative strategy offers. Traders can get stockvolatility  information  from  numerous  resources  on  the  Internet,  but  forthe most comprehensive options data coverage the Optionetics Platinumsite is hard to beat. (Do yourself a favor and take the tour sometime.)
Tools of the Trade: The ADX Index
Although  straddles  enable  traders  entering  the  stock  options  arena  tohave the opportunity to make income on a more short-term basis, strad-dles can be expensive if you are wrong. The key is ﬁnding the right marketconditions that make straddles more likely to be proﬁtable. In addition tothe basic ideas of looking for stocks with consolidation patterns, earningsreports right around the corner, and options that have low implied volatil-ity (i.e., cheap), I have seen some beneﬁt in following and ﬁnding speciﬁcADX patterns.
What is the ADX? The Average Directional Movement Index is a mo-mentum indicator—an oscillator developed by Welles Wilder that seeks tomeasure the strength of a current trend. The key to successful straddles isﬁnding a stock that will make a breakout move. To be successful, we don’tcare what direction the stock moves; we just need a solid move. The ADXis another tool to add to your trader’s toolbox in selecting the right stockcandidates for straddles.
The  ADX  is  derived  from  two  other  indicators,  also  developed  byWilder,  called  the  Positive  Directional  Indicator  (+DI)  and  the  NegativeDirectional  Indicator  (–DI).  The  ADX  ﬂuctuates  between  0  and  100,  al-though  readings  above  60  are  rare.  Readings  below  20  indicate  a  weaktrend often seen as range trading. Readings above 40 indicate a strong di-rectional  trend.  Though  the  ADX  does  not  indicate  a  trend  as  bullish  orbearish,  a  reading  above  40  clearly  indicates  there  is  strength  in  the
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current trend. In other words, if you ﬁnd a stock with a high reading, sayabove 40, this indicates a strong trend but does not identify it as an up-ward  or  downward  trend.  However,  by  looking  at  the  stock’s  chart  youcan  usually  easily  identify  it.  For  a  straddle,  I  am  looking  for  the  weak,nonexistent  trend  that  appears  to  be  ready  to  move  into  a  directionalbreakout. Now doesn’t that sound like a nice straddle opportunity?
So, we can use the ADX to identify potential changes in a stock fromnontrending to trending. How is this task accomplished? A good gauge oc-curs when the ADX begins to strengthen by rising from below 20 to above20. Based on what I have seen, it is a sign that the range trading is endingand a trend could be developing—be it upward or downward. This kind ofscenario is a perfect straddle candidate. The ADX can also indicate that astrong 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  areraising  the  odds  in  your  favor.  Over  the  years,  I  have  become  a  strongtechnical analysis advocate. It has increased my odds tremendously. As aperson becomes more committed to the idea of trading successfully, ﬁnd-ing  the  right  combination  of  trading  tools  is  vital  to  your  success.  Be  itfundamental or technical analysis or a combination of both, you need theright tools for your trading style to better gauge market opportunities.
Figure 8.5 shows a chart of the Oil Service HOLDRS (OIH) along withthe 14-day ADX as well as two directional lines, +DI and –DI. When usedtogether, these three lines are part of the Directional Moving Index (DMI)trading system. Basically, traders will be watching the ADX line to see if itis high or low. Standard use of the ADX includes the idea that an ADX linerising above 20 signals a trending market, while an ADX line falling below40 signals the start of a nontrending environment.
On the chart, we can see ADX rising in November 2003 and crossingabove  20  and  both  directional  lines.  This  signals  that  a  period  of  quiettrading 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 thiscase,  a  straddle  makes  sense.  The  OIH  has  been  trading  quietly,  but  avolatile move is expected. This is an ideal environment for placing a strad-dle. 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  Ad-vanced GET and Proﬁt Source, which allow you to set search parametersto produce a list of stocks that meet the requirement of crossing over anADX of 20. With this list, you can look through the other criteria to ﬁnd astrong candidate and increase your odds for placing a successful straddle.Given  the  current  market  uncertainty,  a  straddle  is  an  ideal  trading
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FIGURE 8.5 OIH Price Chart with ADX Line (Source: Optionetics © 2004)
strategy to deploy. Here’s hoping that all your straddle trades encounterthe most tumultuous of news events.
SHORT STRADDLE STRATEGY
A short straddle involves selling both a put and a call with identical strikeprices and expiration months. This strategy is useful should the underly-ing futures remain fairly stable. It is attractive to the aggressive strategistwho  is  interested  in  selling  large  amounts  of  time  premium  in  hopes  ofcollecting all or most of this premium as proﬁt. In general, this is a neutralstrategy  with  limited  proﬁt  potential  (the  total  credit  from  the  short  op-tions) and unlimited risk. There is a signiﬁcant probability of proﬁt mak-ing  but  the  risk  can  be  very  large,  which  is  why  I  do  not  recommendplacing a short straddle.
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Short Straddle Mechanics
Let’s imagine you are selling a straddle on XYZ Corp. and shares are tradingfor $50 a share in December. The short March 50 call option is trading at$2.50 and the short March 50 put option is trading at $2.50. You forecast thatXYZ is going to continue trading in a narrow range, which results in a de-crease in volatility. Again, if you are expecting a decrease in volatility, youwant to sell options. You want to sell high volatility and buy low volatility.
Remember, XYZ is trading at $50 in this example. You have collected 5points of net premium from the short options. The danger in this trade isthat  your  maximum  risk  is  unlimited  to  the  upside  and  limited  to  thedownside (as the underlying can only fall to zero). Remember, the safesttrades have limited risk and unlimited reward potential or limited rewardwith a high probability of being correct. Although it’s unlikely, XYZ couldgo to zero, the call side has unlimited risk. Luckily, at expiration, only oneside could be wrong. They cannot both be wrong.
Anytime you sell an option, the net credit you receive is the maximumproﬁt. Remember, when you sell options, you do not want market move-ment.  You  want  the  market  to  stabilize  and  go  in  a  straight  line.  In  thistrade, you have collected $500. If XYZ stays between 55 and 45, you willmake a proﬁt. This is referred to as the proﬁt range. When you sell strad-dles, it is vital to identify this range by calculating the upside and down-side breakevens. This will enable you to determine the point at which thetrouble starts. The upside breakeven occurs when the underlying asset’sprice equals the option strike price plus the net premium. The downsidebreakeven  occurs  when  the  underlying  asset’s  price  equals  the  optionstrike price minus the net premium. For example, the net premium for thistrade is 5. Therefore, the upside breakeven is calculated by adding 5 to 50to get 55. The downside breakeven is calculated by subtracting 5 from 50,which equals 45. Thus, your proﬁt range exists between 55 and 45.
As  you  can  see  by  looking  at  the  risk  proﬁle  in  Figure  8.6,  a  shortstraddle  looks  like  the  opposite  of  a  long  straddle’s  risk  graph.  Since  along straddle has a V-shaped curve, a short straddle has an upside-down V-shaped curve because it is the combination of a short call and a short put.This shape clues us in to the fact that short straddles have limited proﬁtpotential and unlimited risk. If a market moves signiﬁcantly from the cen-terline, you have unlimited potential to make proﬁts when buying a strad-dle  and  unlimited  risk  when  selling  the  straddle.  Maximum  proﬁt  isachieved if the market closes exactly at 50 by the expiration date. How-ever, I do not recommend taking on this kind of risk. I include these exam-ples so that you can understand the mechanics of this trade and be awareof the dangers inherent in shorting options.
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FIGURE 8.6 Short Straddle Risk Graph
Exiting the Position
The following exit strategies can be applied for the short straddle example:
• XYZ falls below the downside breakeven (45): You will want toclose out the put position for a loss due to the chance that the put willbe assigned.
• XYZ  falls  within  the  downside  (45)  and  upside  (55)breakevens: This  is  the  range  of  proﬁtability.  The  maximum  proﬁtoccurs  when  the  underlying  stock  is  equal  to  the  strike  price  (50).Options expire worthless and you get to keep the credit.
• XYZ  rises  above  the  upside  breakeven  (55): You  will  want  toclose out the call position for a loss due to the chance that the call willbe assigned.
Selling straddles is a risky trade unless you ﬁnd markets that are notlikely to move away from a centerline. However, there are methods thatcan be utilized to substantially reduce the risks associated with this strat-egy. For example, you may want to purchase a strangle against it, therebycreating a condor (which is covered in Chapter 10). However, due to thefact that a short straddle comes with unlimited risk, I do not recommendits use and primarily teach it for educational purposes only.
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Short Straddle
Strategy: Sell an ATM call and an ATM put with the same strike price andthe same expiration date.
Market Opportunity: Look for a wildly volatile market where you antici-pate a period of low volatility.
Maximum Risk: Unlimited above the upside and limited to the downside(as the underlying can only fall to zero) beyond the breakevens.
Maximum  Proﬁt: Limited to the net credit received. Proﬁt is possible ifthe market stays between the breakevens.
Upside Breakeven: ATM strike price + net credit received.
Downside Breakeven: ATM strike price – net credit received.
Margin: Required. Extensive.
Short Straddle Case Study
A short straddle is a limited reward, unlimited risk strategy that proﬁts ifthe underlying security trades sideways. Though proﬁts can be made us-ing this strategy, it is not one we at Optionetics suggest. Entering unlim-ited risk strategies is usually not a good idea and the short straddle is oneof these. Since a long straddle requires a large move for the underlying se-curity,  it  makes  sense  that  a  short  straddle  needs  a  sideways-moving,range-bound  stock.  However,  because  a  short  straddle  consists  of  goingshort  two  options,  the  risk  is  high  and  the  margin  required  to  enter  thisstrategy would be very large. Nonetheless, let’s look at a real-life exampleof how a short straddle works.
On December 1, 2003, Home Depot (HD) was trading just under $37 ashare. At this time, a trader might have believed the stock was set to tradesideways until late January when retail sales data for the month would betabulated. As a result, a short straddle could be entered. A short straddleproﬁts as long as the stock closes at expiration near the strike used. Sincethis  strategy  beneﬁts  from  time  decay,  short-term  options  are  typicallyused.  In  the  case  of  HD,  January  2004  options  were  used.  However,  be-cause  HD  is  in  between  strikes,  the  trader  needs  to  decide  whether  thestock  will  move  slightly  higher  or  slightly  lower  by  expiration.  Let’s  usethe 37.50 strike for this example.
The January 37.50 calls can be sold for 0.85 and the January 37.50 putscan be sold for 1.60. If ﬁve contracts were entered, the total credit wouldbe $2.45 per contract or $1,225, with unlimited risk. The breakeven pointsare  found  by  taking  the  credit  of  $2.45  per  contract  and  subtracting  it
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from the strike price for the lower breakeven and adding it for the higherbreakeven. Thus, our breakeven points are at 35.05 and 39.95. If HD wereto close in between these points at expiration in January, a proﬁt wouldbe made.
The risk graph in Figure 8.7 shows us exactly the opposite of what wenormally want to see. The proﬁt zone is a very small portion of the graph,with the loss section quite large. This type of risk proﬁle normally means alarge amount of margin will be needed, and this is deﬁnitely the case witha short straddle.
Home Depot did in fact trade sideways until January expiration, butthe move was slightly to the downside, with the stock closing at $34.96. As
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FIGURE 8.7 Risk Graph of Short Straddle on HD (Source: Optionetics Platinum © 2004)
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Short Straddle Case Study
Strategy: With HD at $36.77 a share on December 1, Short 5 January HD37.50 Calls @ 0.85 and Short 5 January HD 37.50 Puts @ 1.60.
Market Opportunity: Expect HD to trade sideways.
Maximum Risk: Unlimited risk to the upside and limited risk to the down-side (as the underlying can only fall to zero). In this case, a loss of –$55 atJanuary expiration.
Maximum  Proﬁt: Limited  to  the  net  credit  of  the  short  options.  In  thiscase, $1,225: [5 × (.85 + 1.60)] × 100.
Downside  Breakeven: ATM  strike  price  minus  the  initial  cost  per  con-tract. In this case, the DB is 35.05: (37.50 – 2.45).
Upside Breakeven: ATM strike price plus the initial cost per contract. Inthis case, the UB is 39.95: (37.50 + 2.45).
Margin: Extensive.
a  result,  this  trade  would  have  lost  about  $55.  If  the  35  strike  had  beenused,  nearly  the  maximum  proﬁt  would  have  been  achieved.  This  is  themajor difference between straddles and strangles. A strangle has a widertrading range, but brings in a smaller credit. A straddle has a larger credit,but a much smaller proﬁt zone.
LONG STRANGLE STRATEGY
Strangles  are  quite  similar  to  straddles,  except  they  use  OTM  options,which  changes  the  dynamics  of  the  trade  entirely.  To  construct  a  longstrangle, you want to buy both an OTM call and an OTM put with the sameexpiration month but different strike prices. The best time frame to usefor this options strategy is at least 60 days. Since the maximum risk is lim-ited  to  the  double  premium  for  the  long  options,  a  strangle  should  beviewed  with  respect  to  how  expensive  the  options  are.  More  often  thannot, one side will be underpriced and the other side will be overpriced.
The strike prices of the options used are the main difference betweena straddle and a strangle strategy. A strangle has strikes that are slightlyout-of-the-money, while straddles use ATM options. For example, if XYZwas trading at about $97, then the XYZ 100 calls and the XYZ 95 puts couldbe purchased to create a long strangle. The advantage of this strategy isthat  the  potential  loss—should  XYZ  remain  at  $97  at  expiration—is  lessthan that of a straddle. The disadvantage is that the stock needs to moveeven further than a straddle for the position to become proﬁtable. Despite
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the  fact  that  the  strangle  might  look  much  cheaper  than  the  straddle,  italso carries more risk.
Long Strangle Mechanics
Let’s create an example with XYZ priced once again at $50 per share. Let’sselect a strangle by going long a September 55 call for $2.50 and a Septem-ber  45  put  for  $2.50  (see  Figure  8.8).  Once  again,  although  you  have  nomargin  requirement,  you  are  still  going  to  have  to  pay  both  premiums.However, you are going to pay less than if you bought a straddle, because astrangle uses OTM options. Unfortunately, even though they cost less, youwill need the market to make even greater moves to ever get your moneyout. This trade is delta neutral because the OTM options combine to createan  overall  position  delta  of  zero  (OTM  call  =  +30;  OTM  put  =  –30).  Themaximum  risk  on  this  trade  is  the  cost  of  the  double  premiums,  whichequals $500: ($2.50 + $2.50) × 100 = $500. Your maximum proﬁt is unlim-ited. As shown by the long strangle’s U-shaped risk curve, this strategy hasunlimited  proﬁt  potential  and  limited  risk.  The  upside  breakeven  occurswhen  the  underlying  asset  equals  the  call  strike  price  plus  the  net  debitpaid. In this case, the upside breakeven equals 60: (55 + 5 = 60). The down-side  breakeven  occurs  when  the  underlying  asset  equals  the  put  strikeprice minus the net debit. The downside breakeven equals 40: (45 – 5 = 40).
FIGURE 8.8 Long Strangle Risk Graph
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Long Strangle
Strategy: Buy an OTM call and an OTM put with the same expiration date.
Market  Opportunity: Look  for  a  stable  market  where  you  anticipate  alarge volatility spike.
Maximum Risk: Limited to the net debit paid.
Maximum  Proﬁt: Unlimited  to  the  upside  and  limited  to  the  downside(as the underlying can only fall to zero) beyond the breakevens.
Upside Breakeven: Call strike price + net debit paid.
Downside Breakeven: Put strike price – net debit paid.
Margin: None.
The proﬁt zones are therefore above 60 and below 40. Unfortunately, proﬁtdepends on a large move in the underlying instruments. A market with ex-tremely high volatility might give you the necessary kick to harvest a proﬁtfrom a long strangle strategy.
Exiting the Position
The following list provides some practical guidelines for exiting a strangle:
• XYZ falls below the downside breakeven (40): You can close theput position for a proﬁt. You can hold the worthless call for a possiblestock reversal.
• XYZ falls within the downside (40) and upside (60) breakevens:This is the range of risk and will cause you to close out the position at aloss. The maximum risk is the double premiums paid out of $500.
• XYZ  rises  above  the  upside  breakeven  (60): You  are  in  yourproﬁt zone again and can close the call position for a proﬁt. You canhold the worthless put for a possible stock reversal.
Long Strangle Case Study
A long strangle is the simultaneous purchase of a call and a put using dif-ferent strikes, but the same expiration month. Since it involves the use of along call and a long put, the cost to enter is high, but less than when using astraddle.  This  is  because  we  are  buying  a  call  that  is  slightly  out-of-the-money as well as a put that is slightly out-of-the-money. As with a straddle,a long strangle should be used on options that have low implied volatility.When a stock has been trading in a range and a break is expected, a longstrangle is one way to proﬁt without predicting the direction of the move.
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