Straddle or Strangle...Witch Is It?

 

'Tis the season to do a little strangling.  In this case our "victim" will be none other than Whole Foods Market (WFM) just because I'm a little hungry....for a few frog legs!  Kidding.  Just keeping those colorful little critters guessing as the "frightful night" approaches.

 

 

Using a strangle options strategy is often just another "lose your money in a fancy way" suckers bet. 

 

 Strangling is an options strategy where the investor holds a position in both a call and put with different strike prices but with the same maturity and underlying asset.  An example of this using a stock priced at $50 is as follows. In order to strangle that $50 underlying stock price you might buy a call at the $45 strike price and buy a put at the $55 strike price.  Buying a call means that you think the price of the stock may rise.  Buying a put mean you may think that the price of the stock is going to fall.

The current price of WFM is at $64.  Hmmm.  Because its dead on the whole dollar (64) looks like I will have use the strangle's evil twin...the straddle.  A straddle is an options strategy with which the investor holds a position in both a call and put with the same strike price and expiration date.  So in this case I will simply buy a November $64 call and a November $64 put.  Shoot, my Halloween theme just shot out of here like a bat out of the batcave.  Wait just a second...I guess I will get to use my Attack of the 50 Ft.Woman poster one more time!

A 50 foot tall women should never straddle a highway on-ramp.  You might as well text and drive instead.  (Oh, why didn't I buy the model with the sunroof?!?...moon roof?)

By buying the 64 strike call and a 64 strike put for .47 and .45 respectively everything is fairly "even Steven".  Remember that .47 for example is multiplied by 100 because there are 100 share for each option contract.  So one call option will cost $47 and one put option will cost $45.

 

Dude looks like a Tyler, no?

 

                                                         Dude looks like a Munch, no?

 

But what would make a monkey want to straddle a Whole Foods Market? 

  The answer is two fold.  First and as per usual I am utilizing a pre-earnings strategy.  Earnings for WFM is November the 6th right after the close.  This strategy is all about the volatility, and the anticipation of a good or bad earnings result can make both calls and puts rise.  This is referred to as the volatility rush, and the plan is to buy a few days before the earning announcement and sell prior to that announcement.  If you don't sell prior to the announcement you may be turning a fairly low risk strategy into a high risk lesson in volatility crush as option prices can deflate immediately after the announcement; another example of "buy the rumor sell the news".

If you are new to options, but observant, you might ask, "why just buy a few days before the earnings announcement, why not buy a few weeks before the announcement."  The simple answer is that options decay like that new car you just drove off the lot.  The right balance between time decay and volatility is key to making $$ using this strategy.

 

View of decaying call or put option.

 

 

...and under magnification.

 

Just because a stock has an earnings announcement upcoming doesn't necessarily make it a good candidate for a pre-earnings straddle though.  An implied volatility history that looks like an electrocardiogram of a healthy, blood red, beating heart is what you may want to look for.

 

Notice the rise of the pre-earnings rush and the fall of the post earning crush?  Keeping your eye on implied volatility (IV) will at least give you a logical reason to enter a trade with a particular stock.

 

 

Let's put this trade in the pumpkin patch for a few days and hope for a Hallowinner.

 

 

 

Postscript 10/31: After all that,  I looked at the wrong options chain so the actual strike prices are incorrect.  Looks like this one is more a trick than a treat.  Maybe a do over next month?

 

Pre-Earnings Straddling of Nvidia (Part Dos of Dos)

This is the third time that I've either strangled or straddled NVDA to showcase my favorite options strategies.  The first time was the big winner with a 70% gain in five days.  The second time resulted in  a 2.5% loss.  This time I got the 2.5% back in the last day of the trade.   I consider that slightly more of a "Woo-Hoo!" than a "Doh!" in Homer-speak.

 The gain occurred in the last day (earning day) which happens as uncertainty peaks.  Sometimes it pays to hold to the very last few minutes before the earnings announcement is made which was the end of the trading day on Thursday.  The chart below illustrates the price action of the call and put compared to the stock price.

 

 

Notice on the last day (red circle) where the stock price didn't move much but both the call and put both moved up slightly.  That's the implied volatility going to work and turning an initial $32 call into a $36 call, and turning an initial $48 put into a $46 put.  Nothing to brag about, but a gain is a gain after combining the final price of the call and the put.

 The mistake that is often made when using options strategies around earnings is to assume that a large move in the stock price after earnings will result in an overall gain.  In this case, look at what would have happened if you sold your straddle the day after the earning announcement.

 Notice in the chart below that the implied volatility has plummeted post earnings ...

 

 

As the chart below shows, the stock price of NVDA actually rose 4.5% after a good earnings result.  This caused the call to shoot up to $56, but the put, without the benefit of the pumped up implied volatility, is now worth only $3. 

Your initial $80 investment was worth $82 if sold just before the earnings announcement (+2.5%), but is now worth only $59 the day after the earnings announcement. (-26.3%).

Related Post: Pre-Earnings Straddling of Nvidia (Part Uno of Dos)

Pre-Earnings Straddling of Nvidia (Part Uno of Dos)

Since I am slowly turning into a neutral strategy monkey, except for that incredibly (and inversely) death-defying, stubborn, mechanical MensaMonkey, I happen to notice that earning were coming out for Nvidia (NVDA) on May 9th after the market closes.  On two past occasions I have used Nvidia as an example on how to use an option strategy called a "long strangle"  which is a neutral strategy that involves the simultaneous buying of a slightly out-of-the-money put and a slightly out-of-the-money call of the same underlying stock and expiration date.

 

Using today's price of Nvidia at around $13.83, the delta neutral play would be to use a similar strategy called a "straddle" which is also a neutral strategy in options trading that involve the simultaneously buying of a put and a call of the same underlying stock, strike price and expiration date.

 

If you know nothing about options you have probably already moved on, or are taking this opportunity to catch a few drooling ZZZZ's., but for the rest of you that have some idea of what a call and a put is, you may wonder what the point is of buying a call and a put of the same strike price.  Don't they just off-set each other?

 

 

Price action of the underlying stock will move the price of the option...when the stock price goes up, the call increases in value while the put decreases in value; when the stock price goes down, the call decreases in value and the put increases in value.  Other factors contribute to the price change of an option.  The one we are most concerned with here is implied volatility.

 

Take a look at the line on the chart that represents implied volatility...

 

 

See the sharp spikes?  These occur consistently as NVDA approaches the earnings date.  We'll call this the volatility "rush".  As implied volatility increases before the earnings announcement, this can cause the price of both the call and the put to increase, even if there is no price change in the underlying stock price.  If there is a large price change in the underlying stock, this will usually result in an increase of either the call or put that results on an overall gain for the straddle (or strangle).

 

When using a pre-earnings straddle or strangle, I buy somewhere between one and five days before the announcement, and sell before the announcement rather than hold the trade through the announcement.  So why do I sell just before the announcement since stock prices can make huge moves in one direction or the other after an announcement is made? Just as there is a volatility "rush" into earning there is also volatility "crush" after an announcement which often deflates the price of an option even if there is a significant price move.

 

Another reason I buy only a few days prior to the earning date is because of the Theta-Monster.  Theta is a measurement of the option's time decay. Yes, that's right, buy an option and the option loses value as time marches toward the expiration date.  Think of theta as a little "Pac-Man" that slowly eats away at the price of the option.  Conversely,  and to confuse matters a little more, theta is your friend if you sell options, instead of buy them.

 

So what options will we be using for this round of NVDA straddling? We can go with the slightly unbalanced 14May call and the 14May put, currently trading at .32 and .48 respectively.  One option equals 100 shares so move the decimal point over two places to the right and you will see that you are paying $80 for this not so quite neutral pair of options.

 

Now we "let bake" until near the end of the day on Thursday and see if the "dough rises".  Of course, if some huge price move occurs before then, there's no need to hold the trade all the way through to the earnings date. (Mmmm..monkey likes bread.) 

 

Related Post: The Pre-Earnings Strangle

 

 

Pre-Market Strangle With A Twist

While the American humans use this week to elect the lesser of two evils, I will use this opportunity to strangle NVDA for the last time this year.  Since NVDA is announcing earnings on November 8th after the market closes, I'll use this opportunity buy the November 13 calls and also buy the November 12 puts using Fridays closing price for each at around .35. That's $35 for each option contract because each contract represents 100 shares ( .35 x 100 shares = $35).  I'll sell these just before the close on November 8th.

 

I do not want hold these through earnings.  The idea is to let increasing volatility and/or price swing in either direction produce an increase in the price of the options.  Holding through earnings may seem like a good idea because drastic price swings can occur after earnings but just as there can be a volatility rush before earnings, there is often a volatility crush after earnings so the gain achieved through a large price swing can be wiped out by the decreased volatility after the announcement. 

 

In this case I am holding the options for no more than four or five days so theta or the rate of decline in the value of an option due to the passage of time is limited.  There nothing worse than buying something that declines in price the minute you buy it...like..umm...everything, except gold maybe.

 Here's a good reason to use NVDA for a strangle...

 

 

Those spikes represent the increased implied volatility, and then the decrease in volatility after earning announcement.

 You can refer back to the last NVDA strangle (which resulted in a five-day 70% gain) here for the set-up and here for the result.  I don't expect those kind of stellar gains but with the added twist of an election on Tuesday who knows what direction stocks will go.  And who cares about direction when you are in a strangle.  We just want something to happen.  So a Romney boost, or an Obama dive, or a market up-turn due to removing election uncertainty will help our cause.  Of course if volatility drops after the election and prices flat-line we will get nada or maybe a small loss. 

 

 Strangles used in this manner are low risk, low reward usually.  So while waiting to see if the self-serving politicians you voted for will win, a strong market reaction to the election could put this strangle in the money.

 

The Pre-Earnings Strangle (Part Deux)

I wish every example that I used to make a point worked out this well. (Refer back to the previous post when I entered this stress-free, pre-earnings strangle trade.) As it turned out, price action for NVDA was the main reason for the impressive gain as this five day chart shows...

although if you compare the implied volatility chart (below) with the one from the previous post you will see there was an increase which can offset that option price-eating greek called theta.

Looking back at the combined price of the call and put we have this...

Friday (at the open) .70
Monday (at close) .76
Tuesday (at close) .81
Wednesday (at close) .90
Thursday (@3:30 pm) 1.19

Remember to move the decimal point over two places to the right since we are dealing with one option contract (100 shares).

Not a bad way to make 70% in five days using a (sort of) neutral trading strategy.

Of course, there is no guarantee that past performance will be indicative of future results as the legal baboons often say. Next time, maybe I'll place a losing trade using the same strategy to show that the downside isn't usually too steep, hence the stress free description of this trade.

Once you have an understanding of the basics of options trading, and if you happen to be a mathophile this book my be useful:

The Volatility Edge in Options Trading by Jeff Augen


No Bart was harmed during the writing of the The Pre-Earnings Strangle part one or deux.

The Pre-Earnings Strangle

Sometimes I think that options are just a more exotic way for the market to take my money. With that attitude, I sometimes straddle or strangle a stock that is approaching earnings. This way I can make a profit without knowing or caring which direction the stock price will move. I won't bore you with defining all the terms that options carry with them but I will give you the reason behind using this strategy prior to earnings announcements.

Let's use the example of NVDA which has an expected earnings announcement next Thursday after the market closes. Since the price just after the open today was around $13.60, I decided to use a strangle and buy the out-of-the-money August 14 calls and also buy an equal number of the out-of the-money August 13 puts. If the price were close to 13 or 14, I would have used a straddle and bought an equal number of puts and calls using either the 13 strike price or the 14 strike price. The plan is to be as delta neutral as possible. Delta is a measure of option value changes to changes in stock price. Clear as mud?

I have five full days until I sell BEFORE the earnings announcement. The price of a bought option declines due to theta (that's Greek for "time eating price) so I buy only a few days prior to the announcement. This type of trade will become profitable if the stock price moves significantly or if the implied volatility increases as the announcement approaches...and it often does as the chart below indicates by the look of all those spikes around the earning dates. If implied volatility increases, the price of the options (calls and puts) can also increase.

So why do I sell before the announcement since stock prices can really move in one direction or the other after an announcement is made? Just as there is a volatility "rush" into earning there is also volatility "crush" after an announcement which often deflates the price of an option even if there is a significant price move.

The beauty of using a straddle or strangle prior to earnings is that risk/reward makes this a relatively safe play...unless you don't believe me and hold through earnings. On Friday, near the open, I bought the August 14 calls for .33 and the August 13 puts for .37.  Let's see where this ends up over the next few days.

If you want to learn more about options, there are plenty of really lousy books on the subject. I think these guys do that on purpose or they have been in the business so long that that they just can't communicate anymore. It's like asking Albert Einstein how to tie a shoelace.

Here is one of my recommendations for learning options if you don't have a clue, and really want one...Options Trading 101 by Bill Johnson

The Magnificent Sigmundo Bails on the Trade

Since I am a monkey, I don't always follow through with the original plan (see yesterday's post).  In this case, as most times when I see gaps occur in price, I tend to change my thinking.  In addition, I usually take advantage of any short-term double digit gain when I get the chance (not including gains from mechanical systems where I rely on specific signals).

You can see by the five day chart below that the SPY gapped down at the open this morning.  It didn't look like it would follow through and continue downward so I expected the gap to fill.  Knowing that the puts had been bought at a price of 1.80 and seeing them now at 2.55, I decided to follow my paranoid instincts and take the money and run with the 42% gain.

 
Does this mean the whipsaw pattern that has been going on will continue or dissolve?   Only time will tell.

You can see that making a profit is more important to me than the need to be right.

Related Post: The Magnificent Sigmundo Attempts to Move the Market