Rivercity,
You have written some great notes over the past several weeks. These notes are especially valuable to our members that have yet to pull the trigger. Although books and paper trading will never give them the warm and fuzzy "kicked in the teeth" feeling that sometimes comes with trading, nonetheless they will hopefully learn from the actions of others.
I thought our investors might benefit from an in-depth look at your trade. I'll be posting frequently on real-life examples like this. Keep an eye out for more soon! I chose your straddle play to better highlight a very powerful tool we have at TradeKing.
The Option Strategy Scanner does not always get its due when we speak of the cutting edge tools available for free with every TradeKing account. To launch this tool, please go to Tools > Option Strategy Scanner. (fyi, this will launch in a separate window; adjust your pop-up blocker accordingly) Before we get to that, let's break down this trade for everyone's benefit.
The play you chose is Play #9 in the Options Playbook. Account holders can check out the online version of this book for more details. (under Education - remember it's free to open an account!)
A straddle is when you buy a call and a put in the same month, with the same strike, at the same time. They are typically deployed by seasoned option traders when they are anticipating a swing in a stock, ETF, or index price but aren't sure which direction it will go. The "sweet spot" for this trade is if the underlying shoots to the moon, or goes straight down the toilet.
Here's a break down of the play:
Strategy: | Long Straddle |
Long leg 1 | Bought QQQ Feb 50 C @ 3.13 |
Long leg 2 | Bought QQQ Feb 50 P @ 2.79 |
Entry | 3.13 + 2.79 = 5.92 Debit |
Max loss | Limited to debit = 5.92 |
Max gain* | Theoretically unlimited |
Lower breakeven* | 44.08 |
Upper breakeven* | 55.92 |
*based on Feb. expiration; I.V. ~ 30% | |
Check out our Profit & Loss Calculator (under Tools) for a visual representation of these numbers. An image is below.
Rivercity, I imagine that you entered this position expecting either 1) the demand for these options to increase between Nov. 20 and Feb. expiration or 2) the QQQQ stock to be highly volatile in the same period or 3) both. Let's take a look at the demand level, a.k.a. the Volatility Chart, under Quotes+Research > Volatility Charts. In the image below, I added some details to assist with this discussion.
For this strategy, examining Implied Volatility (yellow line) may be helpful. We already explained that a straddle is buying a call and a put. Another way to say this is we are "buying" volatility. Although not the only necessary ingredient, increasing volatility surely helps this trade to be profitable. Whenever we buy anything: stocks...options...houses...we want to buy low and sell high. Volatility is no different. If you look at the one-year range for volatility, you can see that it was quite high when you bought the straddle. The level doesn't mean that it can't go higher (it actually did) but the chance of that happening is low. Should volatility decline after you enter, (a.k.a. demand falls), your options will lose value, even if the stock remains unchanged. Volatility helps us make a forecast of what is to come, but the projections of course are not set in stone. Think of it as the role a meteorologist plays in planning your vacation. Highly sophisticated tools are used to give us the temperature, amount of sunshine, precipitation, and humidity. These tools make predictions and are helpful, but eventually we must choose where to vacation, what season to go, and what extra clothes to bring along. It may be useful to know the forecast before entering a trade.
Our Options Guy has written some great posts on volatility:
http://community.tradeking.com/members/optionsguy/blogs/2116-why-do-we-care-about-volatility
Interestingly enough the vol level dropped sharply and then rose again, surpassing the volatility you bought in the last 1-2 weeks. The problem was you had to wait too long for the volatility to come back in your favor. All the while, time decay was working against you, withering away your option premiums.
You escaped with a minimal loss of .92 (5.92 straddle cost - 5.00 put sale). It may not sound fun, but it is really much better than you may have originally thought. The odds were stacked against you from the beginning. For your next straddle play, you may want to start with a stock where the relative implied volatility is lower, perhaps in the lower third of the one-year range. Again, this is not a guaranteed method, but adds to your defenses when braving the markets. (Though unlikely, you still have a shot to be profitable from the calls if the market makes a wild rebound.)
As you might imagine, it may take a lot of time to find such a stock....unless you have a secret weapon. Can you guess? Yep, the Options Strategy Scanner can sure save us some time in a situation like this.
In my next post I will discuss more about this, as well as different things to consider when exiting a straddle.
Thanks, Rivercity, for the opportunity to use your trade for the Community's benefit. Until next time...
This comment and any market data included here were prepared on 1/29/08.
--Nicole Wachs
TradeKing Staff
P.S. If you enjoyed reading this post, check out the brand new All-Star Trades blog. Maybe your trade will be featured next!
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
