|
April 16, 2003
When Straddles and Strangles
Are Your Friend
By John Brasher, CallWriter Publisher
|
I recently read a trading
tips report by a well-known options trader and financial writer
in which he pooh-pooh'd straddles and strangles. He declared
them to be so seldom profitable as to be worthless - a trap
for the unwary or goofy. A straddle is buying a call
and put on the same underlying stock that are both at-the-money
(ATM). A strangle is buying a call and put on the same
underlying stock that both are out-of-the-money (OTM) one
or two strikes. |
|
So this is how they work...
Both the call and put must have the
same expiration. It is also possible to write a straddle
or strangle, but if you do that, both positions are naked... not
for the faint of heart! Here is how each looks:
|
Straddle: |
Stock |
$20.00 |
|
Strangle: |
Stock |
$20.00 |
|
| |
CALL |
AUG
20 |
Cost:
$1.10 |
|
CALL |
AUG
22.50 |
Cost:
$0.75 |
| |
PUT |
AUG
20 |
Cost:
$1.05 |
|
PUT |
AUG
17.50 |
Cost:
$0.70 |
|
You profit from a straddle or strangle when - and
only if - the stock moves enough to put the position in the money.
For example, when the stock is $20, you buy the 20 Call for $1.10
and the 20 Put for $1.05, both of which are conveniently at the
money. Remember, this is not a covered position, so your only cash
outlay is $2.15 to buy the call and put to establish the straddle.
Suppose that prior to expiration the stock gaps to $26, what happens?
The answer is that you are in luck, cowboy! The 20 Call is now in
the money $6 and the premium for it now will be that much or more,
so you can sell the call for a profit of at least $5. What about
the 20 Put? Well, the gap up gutted the put, didn't it? Nobody wants
to put stock at $20 when it brings $26 on the open market. Therefore,
the value of the 20 Put has fallen. The $1.05 premium you paid for
the put now is about $0.40, and you stick another $0.65 profit in
your jeans when you buy back the 20 Put. This is a total profit
of at least $5.65, more than 2.5 times your original $2.15 investment.
The strangle would requires that the stock move more to make the
position profitable, but costs less to establish, since both options
are out of the money. Yo' money, yo' choice. If you get a small
move or no move before expiration, you're out of luck on the straddle
or strangle.
This writer then went on to say that, if one side
of the straddle made you money, then duuuhhhh, wouldn't it have
been smarter to just have taken that side? That is impeccable logic,
except how would you (could you) have known which side to buy or
write? Ouiji board? Coin flip? Call Martha Stewart?
The writer had a point, though. Writing a straddle
or strangle is dangerous if you don't have an edge. And here is
the edge: the high-volatility event (HVE), such as
FDA approval hearings and resolution of major lawsuits and FTC actions.
HVEs are too dangerous for you to take one side of them, but perfect
for the straddle or strangle. Taking one side is to buy or write
either call or put options, but not both. The reason one-sided positions
are dangerous is that you cannot know which way the HVE will be
resolved and thus cannot know which way the stock will move. For
example, the stock can gap up or down hard depending on whether
the FDA approves the drug application or not. In fact, when the
FDA disapproves a drug application, the stock typically gaps down
dramatically and trading will be halted in the stock. Then when
trading resumes the next day, it can open quite down. Put differently,
taking one side of a HVE is guessing - - save it for Vegas. In fact,
a covered write is the single most dangerous position you can take
on a HVE, so don't ever write a covered call or covered put on one.
Which brings us to how you make money on a promising
HVE. The fact that a HVE is impending results in volatility in the
stock. Volatility always presents a chance to make money. And the
HVE always presents a textbook case of volatility. If you want to
get in on HVEs with a chance to make a profit no matter how the
event resolves, instead or buying or writing one side of the event,
you have to create a straddle or strangle. A large gap either way
makes you money on a straddle or strangle. However, you lose money
on a straddle or strangle if the HVE does not occur, is inconclusive
or if the stock simply doesn't gap enough. The more significant
the event, the greater the potential volatility.
According to a noted options expert, the single
best HVE play of all (statistically speaking, based upon research
over several years) is the FDA hearing. The date of an FDA hearing
is known, or findable, these hearings are only infrequently postponed
and are announced in press releases by the companies undergoing
the hearings. The FDA events provide the greatest volatility and,
historically, the largest price moves of all HVEs. Obviously, the
more significant the drug or medical device application is to the
company's fortunes, the bigger the pop from the FDA's decision.
This is why there frequently isn't a huge movement when the company
has many successful products on the market and has revenues in the
billions. There also won't be a huge movement if the hearing relates
to a modification of an existing drug or medical device, only for
those relating to new applications. Finally, you don't want to set
up the straddle or strangle more than 3 trading days prior to the
hearing. Don't tie up your money any longer than necessary.
You may be wondering how to find these FDA events,
since the FDA website (www.fda.gov) does not seem have a calendar
of upcoming hearings for new drug and new medical device applications.
Here's how we do it: we simply keep an eye on CallWriter's Real Time Lists™ -
which present the highest-returning call options. These lists are
loaded with potentially volatile stocks. After all, these options
hit the Real Time Lists™
because of high premiums, and high premiums imply high volatility.
Drug, biotech and medical device stocks with impending FDA hearings
tend to show up on one or more of these lists a few days before
the hearing date. We simply check news on such stocks appearing
on the lists looking for confirmation that an important hearing
is upcoming in a few days.. Are there other ways to find companies
with impending FDA hearings? There probably are many ways, but the
key to making money is volatility, not an upcoming hearing. They
are called High—Volatility Events, remember? The high
volatility implied by the (relatively) high call premiums is what
puts them on the Real Time Lists™
... so what better place to look?
|
