What's the best straddle adjustment?

TK All-Star posted on 02/26/10 at 11:21 AM

Mark Wolfinger weighs how to tweak a straddle once you've put the trade on.
 
Once you've bought a straddle and the market starts to move, what's your next step? A TK client (with the excellent username optionstrategy) posed this interesting question recently in the forums. Optionstrategy writes:

"After setting up a straddle, I have read books about different adjustments to it. Lawrence MacMillen states if the stock goes up a strike, sell the put and buy another put at the current strike to minimize loss. The opposite is true for a downward strike move.

Other books say to leave the straddle and buy and short the underlying stock to scalp it as it goes up and down. I have also read to sell the profitable leg and keep the other. Can anyone comment on the best strategy?  I tend to lean toward the MacMillan."  

 
Nice handle, OS.

Let's start by defining what a straddle is for those who aren’t familiar (OS, I know you are, but bear with me).

A long straddle (buy) consists of the following:
•    Buy a call, Strike Price A
•    Buy a put, Strike Price A
•    Generally, the stock price will be near Strike A
 
Both options have the same expiration month. You're anticipating a swing in stock price, but you're not sure which direction it will go. Straddles are an intermediate-to-advanced trade.

Commission to enter a long straddle at TradeKing will be $11.20.

Your max potential loss is the net debit paid. Max potential profit is theoretically unlimited if the stock goes up. If the stock goes down, potential profit may be substantial but limited to the strike price minus the net debit paid.

(Straddles are multiple-leg options strategies involving additional risks and multiple commissions and may result in complex tax treatments. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.)
 
Now back to your question. First, “setting up” is an ambiguous term.  Straddle sellers also set up the straddle.  For clarity, it’s truly best to use “long” and “short”; or “buy” and “sell”.

There is no "best" methodology for adjusting a straddle.
If anyone tells you there is, run in the other direction. You have your risk tolerance and profit objectives; other traders have their own. That said, it's smart to try to find your own "best", as you're doing here. 

Each of these adjustment methods makes one giant assumption: that you plan to hold the position for quite awhile. I’d like to offer a different perspective, one that is likely to be more beneficial over the longer term than any of the others, since it pays attention to managing risk.

It is a losing idea to buy a straddle with the intention of holding until the options expire. In my opinion, when you buy an option, your goal should be to sell it as quickly as is feasible. When you spend the costly premium to buy a straddle, surely you are expecting something to happen to the stock price. You probably have a specific date by which you expect that "something" to happen. If not, after all, why are you buying a straddle?

If the date comes and goes with nothing happening, recognize that the trade is a loser and get out by salvaging the remaining time premium. If the stock price changes, as you hoped, but it turns out to be a small change and does you no good, then it’s time to exit the trade. That’s a crucial adjustment method. That’s the one that saves you from incurring big losses.
 
Scalping delta results from owning a position positive gamma. But it’s not easy. When the stock rises, you gain delta and become longer and longer. At some point, you sell those extra deltas and get back to owning a delta-neutral position. Once again, as the stock moves you get longer on rallies and your positive gamma makes you shorter on declines. In other words, whichever way the stock moves is good for you.

At some point, you adjust for a second time. Then a third, etc. The goal is to make enough profit from buying and selling stock shares to offset the loss you suffer due to the passage of time.

Knowing when to make that gamma adjustment is tricky.  That’s one reason why it’s best left to more experienced traders.  McMillan’s idea is a much easier way to make these gamma adjustments.

Gamma scalping works best when the stock moves up and down and you can make enough profitable scalps to offset time decay.  
    
Selling the profitable leg has different meanings to different traders. Obviously you understand that you don’t sell the leg when the price moves by $0.25. Thus, how profitable must it be? Enough to offset the cost of the entire straddle? There is no definitive answer, but straddle buying is not a wise strategy in a vacuum.  You must have some reasonable expectations for the underlying stock to make a big price change. When those come to pass, you should be able to exit with a profit.

Gamma scalping is for delta-neutral traders with no specific outlook for the stock.  Such traders seldom buy straddles.

Holding the losing leg? Sure, hold when it’s $0.10. But if it’s $2, would you still hold? I wouldn’t.

The point is that the adjustments you describe requires paying attention to various details. Your description of an adjustment method are a good start at a plan, but you must answer some hard questions before putting that plan into action. 

Example: Using McMillan’s idea, is there a certain price that must be achieved when making the suggested trade? When trading options it’s almost always a losing move to enter a market order.  Limit orders will serve you well.

Does the time remaining before expiration affect the decision? These questions should not be ignored.

Bottom line: Owning straddles is far riskier than it appears to be. It's a short-term play best taken on by experienced traders. Hopefully this post will help you think through the risks and opportunities and decide for yourself when putting on a straddle makes sense for you.  


Regards,
Mark Wolfinger
Founder, MDW Options
TradeKing All-Star Commentator

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Mark Wolfinger maintains a cross-marketing relationship with TradeKing.
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Posted by TK All-Star on 02/26/10 at 11:21 AM

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