Lawrence G. McMillan holds Straddle School for Student's trades.
Similar to a triple-threat situation in basketball, a trader would be satisfied in more than one scenario with the Long Straddle play. A player can either dribble, pass, or shoot, but must do so before time runs out. A straddle is purchased when the trader believes the stock has the ability to move drastically, but the direction is uncertain. With expiration rapidly approaching, the desired movement needs to be sharp and fast.
StudentStocks,
For this trade you bought a one-week straddle on General Electric for 1.25 (purchased on Apr 11th - options expire on April 18th). This trade occurred after the disastrous earnings report had been issued. The question is, "Can one reasonably expect this typically low-volatility stock to move far enough to make this straddle purchase profitable in one week?"
The breakeven points for this straddle are 33.25 on the upside and 30.75 on the downside. If the stock can rise above 33.25 or fall below 30.75, the straddle will have been profitable.
First, let's compute the implied volatility of these options. The stock apparently was somewhere near 32.40 when these options were bought, for at that price, an implied volatility of 35% accurately reflects both the put and the call price with a week to go until expiration. That is a very high volatility for GE options. In fact, on that day, the longer-term options in GE were trading as much as 10 vol points lower (25%) for most contracts. It is not unusual for the nearest-term options to have a higher implied volatility than longer-term options, but this is a quite a discrepancy, especially in GE.
Furthermore, the daily average implied volatility of GE options has rarely exceeded 35% over the past several years. So, in statistical terms, it seems like you have "overpaid" for this straddle. Of course, I'm sure that was the market for these options at the time, so you simply bought "in line" with the market. However, the marketplace was obviously panicked by the recent drop in GE and was overpricing the options.
As it turned out, GE did briefly drop below the downside breakeven point, hitting 31.50 a couple of days later, but one would have had to be lucky to get out there. After that, it rallied a bit and finished at 32.69, only 19 cents from the strike. The actual results don't always determine if a trade was a good trade or not, but this one was "swimming upstream" right off the bat, since the options were so expensive to begin with.
President
To jump in here StudentStocks, I'd like to mention that many traders may find it beneficial to purchase a straddle before earnings. The first main reason for this is pending news may increase implied volatility, which may in turn increase the value of the straddle position. The second reason is sometimes with news comes a greater possibility of a gap move, and if significant enough, may also increase the price of the straddle.
In the case of GE, you can see in the Volatility Chart below (Research+Quotes > Volatility Charts) there is a dramatic increase in Historical or Stock Volatility. This occurred during the first trading session following the announcement. The Implied Volatility rose as well, but the move is much more pronounced in HV. The reason for this is because the stock movement is so uncharacteristic for this company.
Click here for a larger image.
The stock chart below is only for six month, but if you look back over the past ten years, you will see that GE has made very few large gaps. In fact, the last time this stock gapped nearly as much as it did on April 11 was after the market reopened following September 11th. (Research+Quotes > Charts)
Click here for a larger image.
It would be extremely unlikely for a stock like this to make a big move. It is rarer still for it to make two big moves in the same week, especially when it seemed that the cat was already out of the bag with the news release.
Fear not - all was not lost! Although you did lose 34 cents per contract, you decided to take action and exit the trade. This shows promise. And you may have learned some valuable lessons to carry forward. Believe me, I wish my "lessons" only cost that much! If you would like to read more on this subject you may find the last several blog posts (and their comments) interesting and quite relevant. Final Sale on Seasonal Items, Options wrapped up like a Pretzel, and GOOG Earnings and Volatility.
I would be interested to learn more about your reasons for entering and exiting this trade. I look forward to hearing from you. Thanks for taking the time to share your trades with us.
TradeKing Staff
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This comment and any market data included here were prepared on 4/19/08.
ROOKIE'S CORNER
The Play: Long Straddle - Play #9
This post best suited for: All levels
Outlook: Volatile
Who should run this play: Veterans and higher
Trader: StudentStocks.Blogspot.com
Trade Status: Closed; entry and exit data
Trade Recap:
GE = 32.05 -4.70 as of close 4/11/08
4/11 2:47 pm Trade 1 Bought to Open 1 GE April 32 put @ 0.59
4/11 2:49 pm Trade 2 Bought to Open 1 GE April 32 call @ 0.66
Long 1 GE April 32 Straddle @ 1.25
4/15 12:25 pm Trade 3 Sold to Close 1 GE April 32 put @ 0.54
4/16 3:58 pm Trade 4 Sold to Close 1 GE April 32 call @ 0.37
Sold 1 GE April 32 Straddle @ 0.91
Current market Parity=0.69; GE=32.69 on expiration close
Trade Result: -27% loss on investment; $0.34 loss per contract
Trade Duration: 6 days
Trade Note: "first leg of a straddle" - StudentStocks long straddle entry
Next Earnings Announcement: 7/11/08 unconfirmed
The Play: Long Straddle - Play #9
A long straddle is the best of both worlds, since the call gives you the right to buy the stock at Strike Price A (32) and the put gives you the right to sell the stock at Strike Price A (32). But those rights don't come cheap.
The goal is to profit if the stock moves in either direction. Typically, a straddle will be constructed with the call and put at-the-money (or at the nearest strike price if there's not one exactly at-the-money). Buying both a call and a put increases the cost of your position, especially for a volatile stock. So you'll need a fairly significant price swing just to break even.
Advanced traders might run this play to take advantage of a possible increase in implied volatility. If implied volatility is abnormally low for no apparent reason, the call and put may be undervalued. The idea is to buy them at a discount, then wait for implied volatility to rise and close the position at a profit.
BREAK-EVEN AT EXPIRATION
There are two break-even points:
- Strike A plus the net debit paid. (32 + 1.25 = 33.25)
- Strike A minus the net debit paid. (32 - 1.25 = 30.75)
THE SWEET SPOT
The stock shoots to the moon, or goes straight down the toilet.
MAXIMUM POTENTIAL PROFIT
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.
MAXIMUM POTENTIAL LOSS
Potential losses are limited to the net debit paid.
MARGIN REQUIREMENT
After the trade is paid for, no additional margin is required.
AS TIME GOES BY
For this play, time decay is your mortal enemy. It will cause the value of both options to decrease, so it's working doubly against you.
IMPLIED VOLATILITY
After the play is established, increasing implied volatility is your best friend. It will increase the value of both options, and it also suggests an increased possibility of a price swing. Huzzah.
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.
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 Community, 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.
Lawrence G. McMillan has a professional business relationship with TradeKing.
