Long Straddles and Strangles: Setup, Risks, and Uses Disclaimer Options involve risks and are not suitable for all investors. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options, sent to you in previous communication. Additional copies may be obtained by calling TRADEKING at 877-495-KING visiting www.tradeking.com/odd or by downloading the file in the pop-up window on your screen. Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments. Please consult a tax advisor. Any strategies discussed and examples using actual securities and price data are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results. Consider the following when making an investment decision: your financial situation, your risk profile and transaction costs. System response and access times may vary due to market conditions, system performance, and other factors. The projections or other information generated by TradeKing's tools regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Market timing is a complex investment strategy which involves risk and may incur additional commission costs. 1
Disclaimer The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts will be correct. While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility, there is no guarantee that this forecast will be correct. Webinars are provided for educational and informational purposes only. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating the merits and risks associated with the use of TradeKing's systems, services or products. TradeKing selects and defines as All-Stars certain independent market commentators who are recognized industry personalities and experienced traders. TradeKing All-Stars provide timely market commentary via the TradeKing All-Star Webinars. Each All-Star commentator's bio, related qualifications and disclosure as to their relationship with TradeKing can be found on the All-Star roster, available at http://community.tradeking.com/members/tk-all-star/details. The selection of All-Stars commentators is solely based on the quality and style of the content provided. TradeKing does not measure, endorse, or monitor the performance or correctness of any statement or recommendation made by independent All-Stars commentators. Supporting documentation for any claims made by Brian Overby will be supplied upon request by the author of the webinar, who is solely responsible for the views expressed here. Send a private message to All-Stars using the link below the profile image. Long Straddles and Strangles: Setup, Risks, and Uses 2
Four Basic Positions CALL PUT Buyer (long) Right to buy Right to sell Seller (short) Obligation to sell Obligation to buy 5 Long Straddle XYZ @ 50 Buy 1 XYZ 15-day 50 Call @ 3.60 Buy 1 XYZ 15-day 50 Put @ 350 3.50 Net Debit 7.10 Commission $6.25 Max Profit = Unlimited Max Loss = 7.10 (debit paid) Two Break-Evens (BE) 50 + 710 7.10 = 5710 57.10 50-7.10 = 42.90 Implied Volatility 80%, Interest Rates 5 ½% No Dividends 6 3
Long Straddle P&L Diagram Profit & Loss 10 8 6 4 2 0-2 -4-6 -8-10 XYZ @ 50 Buy 1 XYZ 15-day 50 Call @ 3.60 Buy 1 XYZ 15-day 50 Put @ 3.50 42.90 Break-Evens 57.10 40 45 50 55 60 65 Stock Price at Expiration Implied Volatility 80%, Interest Rates 5 ½% No Dividends Commission $6.25 7 Long Strangle XYZ @ 52.50 Buy 1 XYZ 15-day 55 Call @ 2.75 Buy 1 XYZ 15-day 50 Put @ 2.50 Net Debit 5.25 Commission $6.25 Max Profit = Unlimited Max Loss = 5.25 (debit paid) Two Break-Evens (BE) 55 + 5.25 = 60.25 50-5.25 = 44.75 Implied Volatility 80%, Interest Rates 5 ½% No Dividends 8 4
Long Strangle P&L Diagram Profit & Loss 10 8 6 4 2 0-2 -4-6 -8-10 XYZ @ 52.50 Buy 1 XYZ 15-day 55 Call @ 2.75 Buy 1 XYZ 15-day 50 Put @ 2.50 44.75 Break-Evens 60.25 45 50 55 60 65 Stock Price at Expiration Implied Volatility 80%, Interest Rates 5 ½% No Dividends Commission $6.25 9 Long Straddles and Strangles: Setup, Risks, and Uses Volatility 5
Volatility Historical the annualized standard deviation of the past stock price movement Implied volatility that justifies an option s current market price. also annualized, is found using an option pricing calculator 50 Vol = 80% 10 50 x.80 St. Dev. = 40 68% 90 11 One Standard Deviation Move (OSDM) To Calculate a OSDM: OSDM = Stock Price x I.V. x Calendar Days to Expiration 365 If the At-The-Money Implied Volatility equals 80% and the Days to Expiration equals 15 then the approx OSDM equals: OSDM = 50 x.80 x 15 365 = 810upordown 8.10 12 6
Probability Distribution - 80% Volatility 50 15 Days 41.90 58.10 30 Days 45 Days 38.46 61.46 35.96 68% 64.04 13 Long Straddles and Strangles: Setup, Risks, and Uses Time Decay, Delta and Gamma Why do we care? 7
Time Decay of ATM Call Option 2 1.73 Option Premium 1 1.41 1.00 0 90 60 30 0 Days to Expiration 15 Delta Example I Delta: The amount a theoretical option's price will change for a corresponding one-unit (point) change in the price of the underlying security. Stock @ 50 Strike is 50 3 Month Call $3 16 8
Delta Example I Delta: The amount a theoretical option's price will change for a corresponding one-unit (point) change in the price of the underlying security. Stock @ 50 Strike is 50 3 Month Call $3 3.50 Non-Textbook Definition 51 The delta is the probability of the option being in the money on expiration. 17 Delta Example I Delta: The amount a theoretical option's price will change for a corresponding one-unit (point) change in the price of the underlying security. Stock @ 50 Strike is 50 3 Month Call $3 3.50 Non-Textbook Definition 51 4.10 52 The delta is the probability of the option being in the money on expiration. 18 9
Delta Example II Delta: Non-Textbook Definition The delta is the probability of the option being in the money on expiration. Stock @ 50 Call Strike is 50 1) One Day to Expiration 19 Delta Example II Delta: Non-Textbook Definition The delta is the probability of the option being in the money on expiration. Stock @ 50 51 Call Strike is 50 1) One Day to Expiration.50 2) Ninety Days to Expiration.50 20 10
Delta Example II Delta: Non-Textbook Definition The delta is the probability of the option being in the money on expiration. Stock @ 50 51 Call Strike is 50 1) One Day to Expiration.50? 2) Ninety Days to Expiration.50? 21 Delta Example II Delta: Non-Textbook Definition The delta is the probability of the option being in the money on expiration. Stock @ 50 51 Call Strike is 50 1) One Day to Expiration.50.90 2) Ninety Days to Expiration.50.60 22 11
Long Straddles and Strangles: Setup, Risks, and Uses Long Straddle & Strangle Criteria Long Straddle & Strangle Criteria 1. Expiration (2 to 10) days out. Around a known event. 2. Decide either to do a Straddle or a Strangle. I. Opt for a straddle only if the underlying is within $.25 of a strike line. The straddle will cost more then a strangle, but will break-even with a smaller move and will have less chance of a 100% loss. II. Choose a strangle if it is more then $.25 away from a strike. Beware, it will cost less then a straddle, but will require a bigger move in the underlying to break-even and will have a higher probability of a 100% loss. (Must Expect a BIG move in a short period of time!) 24 12
Long Straddle & Strangle Criteria 3) Open Interest equal to 30 times the number of contracts you are trading. (for each leg) 4) Calculate the OSDM of the underlying. 5) Calculate the Distance to the Break-Even points (DBE) I. It is equal to the debit paid for the trade if it is a straddle. II. Add the cost of the trade to the call strike for the upper break-even and subtract the cost of the trade from the put strike for the lower break-even. 25 Long Straddle & Strangle Criteria 6) The OSDM should be greater then or equal to the DBE. 7) Review the last few earnings events that occurred on the stock and see if the underlying has ever made a 1 ½ times the One Standard Deviation Move (OSDM). If it hasn t don t do the trade. (cost of straddle if few days left) 8) Set a profit value and a loss value for the trade and be diligent about exiting when your target prices are realized. 26 13
Things to Think About If only a few days remaining to expiration and ATM, the cost of the straddle should be close to the OSDM. Probability of Success Low Probability of underlying making more then a OSDM. Straddles are more enticing the Strangles. Less of a move to breakeven and a low likelihood of losing your entire investment. Gamma is the Greek that causes a straddle to accelerate. High Gamma means high Theta. Maximum profit is unlimited. Don t risk too much Low probability of success. If longer term - strangles okay - still not a big fan. 27 Upcoming Webinars Thursday, June 2 at 5pm ET Adjusting Credit Spreads, part 2 with Dan Sheridan of Sheridan Options Mentoring Tuesday, June 7 at 5pm ET Trading Performance with NASDAQ OMX Alpha Index Options with Paul Jiganti of NASDAQ OMX Tuesday, June 14 at 1pm ET How to Choose Your Strategy, part 1: Your Outlook on Direction and News with Nicole Wachs of TradeKing Tuesday, June 14 at 5pm ET Using TradeKing s Option Scanner with Jack Walker of ivolatility 14
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