Lawrence McMillan praises a top-notch exit.

You know news is pending on a certain stock, possibly an earnings report. Not only that, you are expecting the stock to make a significant move on that news. The Long Straddle or the Long Strangle would be the common choice here. The strangle was covered recently in an earlier post. For more on the straddle, read on!

THE PLAY - Long Straddle

TRADE FORMATION

On June 3^rd at 1:52 pm, Community member Bobo1510 entered the following:

      Strike A Call: Bought to Open 1 TOL June 22.50 Call for 0.52

      Strike A Put: Bought to Open 1 TOL June 22.50 Put for 1.63

      Stock at entry: TOL near 21.50

      Straddle entry: 2.15 debit

      Maximum gain: theoretically unlimited

      Maximum loss: debit paid of 2.15

      Break-even points at expiration: 24.65 (Strike A - total debit) and 20.35 (Strike A + total debit)

On June 5^th at 2:30 pm, bobo1510 closed the call.

      Strike A Call: Sold to Close 1 TOL June 22.50 Call for 0.15

      Loss on call side: 0.15 - 0.52 = -0.37 (exit price - entry price = result)

On June 9^th at 9:30 am, bobo1510 closed the put.

      Strike A Put: Sold to Close 1 TOL June 22.50 put for 3.08

      Gain on put side: 3.08 - 1.63 = +1.45

      Straddle result: +1.45 + -0.37 = +1.08 profit less transaction costs

      1.08 / 2.15 = 50% ROI in six days

Simply stated, the goal is for the stock to move sharply to one side and then exit the trade. A well- executed, more advanced exit is implemented below. For more straddle knowledge, please check out Play #11 of The Options Playbook located in TradeKing's Education Center.

ALL-STAR COMMENTARY - by Lawrence McMillan

As stated by the trader, "Hoping for some movement from the TOL (Toll Brothers) earning report." This is an "event-driven" straddle buy.  That is, one buys a straddle not because he thinks it is statistically cheap (in fact, its implied volatility may actually be quite high), but rather because he knows a corporate event is about to force the stock to make a volatile move.  These events include earnings reports, major lawsuit verdicts, and things such as FDA hearings or drug trial tests for biotech stocks.

One can always determine the option market's estimate of the event's effect by looking at the price of the near-term straddles.  In this case, the TOL June 22.50 straddle was selling for 2.15, during the trading day on June 3^rd, with TOL trading near 21.60.  Earnings were to be reported that night, after the market's close.  Thus, the option market's best estimate of the forthcoming move in TOL was about 2.15 points.  It is surprising how often the option market under-estimates the volatility of events such as these.

This trader rightfully felt that TOL had the power to move farther than that on its earnings announcement.  He doesn't say how he determined that, but in general one would look at past movements of the underlying on its earnings announcement.  In this case, we are hoping for a move of more than 10% (the straddle is selling for almost exactly 10% of the stock price).  One would want to see that TOL made percentage moves of that much or more in the past.  As you can see from Figure 1 that has not exactly been the case:  TOL doesn't appear to gap on its earnings announcements, as many stocks do, but it does seem to eventually move a 2 to 4 points over the days after an earnings announcement.

Click here for a larger stock chart.

As it turns out, TOL issued a very complicated earnings report, including writedowns, so it was almost impossible to compare actual results with analysts' estimate.  The stock opened the next morning (after reporting earnings) down only 10 cents.  However, the stock was weak for the next few days, eventually trading down to 19.19 on June 8^th.  Then it bounced up about 60 cents or so into the close.  The trader correctly, in my opinion, sold off the call when it was clear the stock was headed lower. In addition, the trader correctly used a "trailing stop on the "Put" end of TOL (Toll Brothers) Straddle" because he "wanted to save my profit, but also wanted to let it ride" - eventually exiting that as well when the stock traded higher on the morning of June 9^th.

In summary, I'd say this position was well traded but I'm not sure the straddle purchase was really justified in terms of TOL's past movements after earnings.  While I like event-driven straddle buying, I would prefer to see a much more consistent track record of large stock gap movements in the past, before committing capital to any one event in the future. 

--Lawrence G. McMillan

President

McMillan Analysis Corporation

All-Star Commentator

For a list of previous All-Star Trades, please click here.

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This comment and any market data included here were prepared on 6/16/08.

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.

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