Doc Maher gives the play by play for EnglishTeach.
Pent-up anger and steam-rolling decisiveness may not sound like good qualities in a friend, but boy do they come in handy after buying a straddle. Rage boiling beneath the surface is akin to increasing implied volatility levels in options. Certainty of movement is parallel to the desired path of the stock on which you own a straddle. Here Doc Maher discusses a trader's idea, offers ways to improve, and walks through a current opportunity.
In an earlier post I looked at a straddle on GOOG. In that particular case Google moved so much on earnings that it overcame the Implied Volatility crush. As I was looking through the blog entries, I noticed an entry of yours. You were contemplating a strangle on EBAY on 4/16. Ebay announced earnings after market close that day. Since I have been talking about straddles and Implied Volatility I thought that I would look at what would have happened if I had taken a straddle on EBAY just before 4/16 earnings.
Below is a chart of EBAY for the last few days. Since EBAY was around 32 I decided to look at a straddle at 32.5 using the May options. That is buying a May 32.5 Put and Call. On the chart I have put the price of that straddle at the close of each day. (Research+Quotes > Charts)
Click here for a larger EBAY chart.
So if we had bought the straddle on 4/16 we would have paid around $3.20. However after the earnings on 4/17, the straddle dropped to $2.70 even though EBAY closed around $31.75, down about $0.50. By 4/18 the straddle was down to $2.35. So in a very short time the straddle lost $0.85 or 26.5% on very little stock movement. Why? Well let's look at the Implied Volatility chart. (Research+Quotes > Volatility Charts)
Click here for a larger EBAY IV chart.
As you can see the IV dropped dramatically after the earnings announcement, which means that the options prices dropped. This is why this strategy would have lost even though the stock didn't move.
OK, the point is to make money not lose it so how could we use this strategy to capture implied volatility? Well, if you look at the last earnings you can see that the IV moved up from about 35 to 60 just before earnings. If we had bought when the Straddle before the IV started to move up and exited before it dropped we may have been able to capture some value. Why use a straddle or other delta neutral strategy? Because we want any stock movement that may happen between the time we enter this trade and the time we exit it to help or at least not hurt. In the case of a straddle, any stock movement should help our cause.
So for our next example I'll chose something that has its earnings announcement a little less than a month away, ADI. I hold no positions in Analog Devices and I have no opinion about it, it's just convenient because it will have its earnings announcement between May 19 and 25. (5/21 earningswhispers.com, unconfirmed)
Look at the following price and IV charts for ADI.
Click here for a larger ADI chart.
Click here for a larger ADI IV chart.
We can see that ADI regularly has its IV move up in anticipation of earnings even though we don't see major gaps in the stock price. This movement usually starts about 1 month before the announcement then drops right after it. So if we anticipate this happening again maybe we can capitalize on the IV move with a straddle. Let look at a straddle at 32.50 using the June options, since the announcement is in May. From the chart above we can see that the IV hasn't move up yet. However in the past we see moves of 20 to 25 points. So here is the current P&L for the June straddle. (Tools > Profit+Loss Calculator)
Click here for a larger ADI Profit+Loss graph. (Image 5)
Total cost is $3.85, with 64 days to expiration. If we get a 25 point move in the IV again the P&L would look like this:
Click here for a larger ADI Profit+Loss graph. (Image 6)
This shows a $2.10 profit with no stock movement or 2.10/3.85 = 54% gain. And any stock movement would only make this bigger. The problem is that we haven't taken into account the time decay. If we assume that earnings comes out on May 21st we would have to hold this until then and there would only be 31 days to expiration. This would look like this:
Click here for a larger ADI Profit+Loss graph. (Image 7)
So the IV move of 25 points just about canceled out the loss from holding the position for the month. Unless the stock moves we won't make anything. And after earnings, the IV will probably drop back to where it was ~30 days before the announcement, which will put us here:
Click here for a larger ADI Profit+Loss graph. (Image 8)
So if the stock doesn't move on earnings out side of the break evens of $26.50 and $33.55 this trade ends up in a loss.
So how does this help us? Well if we get the IV move and some stock move before the earnings announcement we can exit with a profit. Remember that there is a month for the ADI to make some sort of move. If not we could exit without a loss if the IV moves but the stock doesn't or we could take our chances with the earnings announcement and the IV crush. The problem is there is no guarantee that ADI will pick up 25 points of IV or that it will move in price.
Bottom line: Straddles and strangles are usually thought of as strategies to capitalize on price movement of the stock. However they can be a strategy to capitalize on an expected move up in IV. In fact this is the way I usually hear about these strategies being used. That is as a way to capture IV. However note that with this strategy we barely covered the time decay with a pretty significant move in IV. This does reduce the risk somewhat if we get the expected IV gain however.
There are many other strategies that try to capture an increase in IV and we'll discuss some of them in later posts.
Until then I hope this helps you understand the somewhat complicated concept of capturing IV. Please keep a look out for a follow up installment for this sample trade.
"Income Trader"
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This comment and any market data included here were written on 4/21 and 4/29/08.
ROOKIE'S CORNER
Straddle
A long straddle is the best of both worlds, since the call gives you the right to buy the stock at Strike Price A (32.5) and the put gives you the right to sell the stock at Strike Price A (32.5). 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.
- Strike A minus the net debit paid.
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.
'Rookie's Corner' is an excerpt from TradeKing's The Options Playbook.
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.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
