How does a trader get hurt with this strategy?

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Leslie Haynes
5 years ago
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2 This is a two part question. Can you define what volatility is and the best strategy you feel is available to traders today to make money in volatile times? Sure. First off, there's essentially a very quantitative mathematical way of defining volatility and then there's probably a more intuitive one. I think it's helpful to think about volatility intuitively. The best measure of that volatility is what's called volatility index, the VIX. Essentially what the volatility index gauges is when the markets are at levels of uncertainty and that are high when there's a lot of concern that markets will drop then the volatility index is high. And when there's a lot of complacency in the market or a lot of expectation that markets will go higher, the volatility index is low. Typically what that says is the volatility index moves opposite to the direction of the market. To answer your second question, the most profitable strategy is called the straddle. Certainly it's the one that I consider to be the best strategy in volatile times, and here's why. When a market has gone on a tremendous run or when it's declined dramatically, and you can think about this for either a stock or the market itself, typically a market does not stay at those elevated levels for long and it doesn't stay at the plateau levels for long. More often than not a market is actually climbing what's called the wall of worry. It's steadily climbing. Most people are concerned it's going to fall, and yet it keeps finding a way to inch ever higher. Then, when complacency is high eventually a market sucks in people thinking well... the worry disappears, it dissipates, and people think well it's always going to go higher. At that moment it pulls back and shocks people. The volatility kicks in, the volatility index spikes, and there are fast and sharp moves in the market. The best time to employ a straddle or strangle is actually at this time when a market has moved quite dramatically to the upside as it did during the election or post-election results. It moved very strongly to the upside. If there's a correction, a sharp correction, you will see that the volatility index will spike and a straddle will become very profitable. It becomes very profitable for two reasons. One, the price of the stock market itself declines which means that the straddle, which is a combination of a call option and a put option, makes a lot of money. The call loses money but the put option makes more money than the call option loses. Secondarily as the volatility index increases, which it does so during a declining market, the options themselves, even if there's no price movement, even if only volatility increases, the options themselves become more expensive. When there's simply the expectation of a movement, options become expensive. It's actually possible to profit with a straddle even if there's no movement, but because of the increased implied volatility in the options, which is a component of

3 the options pricing, a market can stay precisely flat and you can still profit. If the move takes place either dramatically up or down, you can also make money. In the case of a market that has moved very much to the upside what a lot of investors do is they try to bet that the market will pull back, and they're often wrong. The reason the straddle is an extremely attractive strategy is that even if you're completely wrong in your direction and the market doesn't crash, it doesn't fall, it doesn't drop, volatility index doesn't spike higher, even if none of those things take place or you're 100% wrong in your expectations and the market continues higher and higher and higher and higher, much higher and much further than anybody would've expected right after the election, if that happens you still make money. Whether the market goes up or whether the market goes down, you can still make money with a straddle. In volatile markets the straddle is the best strategy to employ. How does a trader get hurt with this strategy? The way this strategy fails to win or make money is if nothing happens in the market. If it turns out that you purchase a straddle, and for example a stock is at $100 a share and your expectation that the market will move up or down over the next call it 45 days or 60 days, and in 45 or 60 days it's gone absolutely nowhere and it's still at $100 at that time, at that point you can certainly lose money. In fact the options, because you're purchasing them, they lose a little bit of value every single day. Your bet is that when you purchase a straddle that the market will move more than the cost of the options. If it does, you make money. If it doesn't, you end up getting hurt. The natural tendency of a market is to move more than investors expect. It moves more further to the downside than most expect. It moves further to the upside than most expect. For that reason the straddle tends to be a very successful strategy because the movement of the market tends to very regularly exceed the price that a typical investor expects the market to move in, creating a profit. Another very good application of a straddle is prior to an earnings event. Like clockwork four times a year you know that there are going to be earnings announcements on companies. If you can put a calendar note on your wall, a Post- It note that says 30 days before Google earnings, Alibaba earnings, Apple earnings, whatever the stock might be, 30 days before that I'm going to look to purchase a straddle. Then, right before the event, right before the earnings announcement, you sell both options. You'll often find that the straddle is at a tremendous profit without having to risk or go through the earnings event and wonder which way will the stock go when the company reports earnings. Will it be up? Will it be down? You don't even have to worry. You can make money, and the reason is that coming up to an earnings announcement options become very expensive.

4 That's very predictable. Each and every quarter, every single quarter, options become very expensive right before earnings. If you know that 30 days ahead of time something is going to become expensive and you can buy it cheap, why would you not do that? It's like clockwork available to every investor every single quarter on many, many stocks. It sounds a little complex. Is this something that beginner traders should stay away from? It's not complex actually in this sense. It simply requires the purchase of one call option and one put option at the same time. If you think about a call option as something that makes money when stocks go up and a put option as something that makes money as stocks go down, if you were to buy both at the same time, all you really care about is that there's going to be a lot of movement over the timeline you purchase the options. In that respect it's very simple. If you're an absolute beginner trader, the big gotcha that would keep you away from this strategy is that eventually the options expire worthless. If you're completely new to options and you're not sure how that process of expiration works, then it's worth steering clear and looking to some other position that incorporates stocks and options. If you're looking to goose a return because you already have enough stocks in your portfolio and you're looking for a big return, a straddle is probably the best strategy to take advantage of volatility and in very short periods of time can generate returns of 30%, 40%, 50% even 100% particularly around earnings time. That's great. How much time per day does this take out of someone's life? Just literally a couple of minutes a day. In fact with a straddle it's probably a position that requires least maintenance, and the reason is that the way most people apply a straddle is they bet on a company moving a lot higher or a lot lower after an earnings announcement. So, the day before earnings they often buy the options and if the stock moves up or down a lot the next day when earnings are reported they make money and they cash out. So, literally it can be a five minute application the day before earnings to put on the trade and five minutes to take it off the next day. Traders who've been around the block a little longer tend to not buy options the day before earnings and hope for a big move up or down the next day. Like I said, what they tend to do is they buy options 30 days before the event and know that guaranteed certainly with a very high probability those options are going to be very expensive the day before earnings and they can sell them back at a big profit without relying on a big stock movement the next day after earnings. Do you have any braggable points, braggable instances where you've done this around earnings and made, like, a bunch of money?

5 Yeah. The stock that has been most successful for me is Alibaba. I would certainly suggest that if you're looking at a straddle you stay clear of boring stocks. So, stay clear of a Microsoft. Stay clear of a General Motors for example. Stick with a stock that has a history and tendency of moving a lot. Alibaba has very regularly 20, 30 point swings and 20%, 30% swings in stock price over 3, 4, 5, 6 month periods. You can often buy options for that timeline which will virtually guarantee a profit. Another stock that is an absolute winner time and time and time and time again for a straddle is Netflix. If you ever look at earnings announcements for Netflix, you'll often find overnight the stock after reporting earnings is up or down 20%. It often then continues that run by another 10% or 15% within 4 or 5 days. As long as the options aren't building in a movement of 20% or 30%, if you can buy them when they're building in an expectation of 10% and the stock moves 30%, you can generate a return of hundreds of percent literally within hours. Those two are my favorite stocks to do it on. Okay. For our readers who want to learn more about this particular strategy what advice could you give them? What direction should they be looking? I think one of the better sites actually out there for straddles is Investopedia. They have a really good explanation not just of the straddle but a sister strategy called the strangle. There are sites also out there such as Urban Dictionary which has visuals of the straddle. If you're a more visual rather than a text based person and you want to actually see what it looks like on a risk reward graph, the Urban Dictionary has really good visuals. The CBOE, Chicago Board of Options Exchange, also has a very comprehensive section on understanding how to buy straddles.

Don Fishback's ODDS Burning Fuse. Click Here for a printable PDF. INSTRUCTIONS and FREQUENTLY ASKED QUESTIONS

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