Newbie Strategy Question

Discussion in 'Options' started by Jayzee, May 20, 2009.

  1. Jayzee


    An option trader told me that he uses the following strategy. Please tell me what do you think, and whether or not this strategy will work, since I am not sure:

    Suppose the stock price is 20. You should buy 1 call for a strike price of 22, and one put for a strike price of 18 assuming that these strike prices have a high delta. You should buy these calls and puts 3-4 weeks before the quarterly earnings report of the company, with an expiration date of 4 months. You should choose the underlying stock based on volatility. Now when the quarterly report comes out, and if there is a movement, whether up or down, you will make money. Suppose there is no movement, then you immediately sell your call and put with 3 months still remaining before its expiration date, and you will be able to get 80-85% of your investment back due to time value of money.

    Please comment. Is this a valid strategy? Does it work?

  2. It's valid, works part of the time, and is far more complicated than you believe.

    This will only work under the right circumstances and that means plenty of back-testing for you. Each stock is different and the timing of buying the options is critical.

    Do not try any shortcuts. You must understand how options work, why implied volatility is important, what makes implied volatility rise and fall etc. If you believe you can pull this off without taking the time to understand options, you are making a big mistake.

  3. spindr0


    Mark gave you a good answer and I should probably leave well enough alone. But I can't :)
    As he suggested, this is way more complixated than you think.

    First, OTM strikes as suggested in your example will not have a high delta. But I s'pose that's not really very important since you want a make money now strategy.

    In order to profit with a 4 month strangle (your position) that's 2 pts out of the money on a $20 stock after a month of time decay, your stock will have to move 15-20%. That's just to break even. There are scenarios where the strangle might profit prior to the earnings release but I'm trying to keep it simple.

    With no movement, there's no way you will salvage 80-85% of your investment a month later without an implied volatility expansion.

    Again, as Mark suggested, learn how options work before risking hard earned money... even hard inherited money :)
  4. Jayzee


    Mark and Spindr, I greatly appreciate your replies. Mark, I am in the process of learning, and I must say that I have also been studying your very informative blog. So Spindr, like you said, it will be very difficult to salvage 80-85% of the value of my option in this scenario. So how much will you say will be a realistic number? maybe 50%? I know each stock is different and IV makes a difference, but I was just trying to get a general idea. I know there are dozens of option trading strategies, so I am just trying to stick to one simple strategy.
  5. spindr0


    It can't be quantified because there are multiple variables (initial IV, subsequent IV, time decay, B/A slippage, narrow vs wide B/A spreads, price movement). It will vary from position to position so you need to model some positions in order to have a better idea.

    If it were only that easy
  6. That's a reasonable idea, but it's not the strategy <i>per se</i> that determines your profitability. It's the way you manage risk. So please don't ignore risk in your quest to learn more about options.