Simple Strategy

Discussion in 'Options' started by Eldredge, Nov 26, 2003.

  1. I was hoping to get some input on a very simple strategy I am considering.

    I have noticed that quite often (I don't have good enough data to know exactly how often) a stock will move far enough during the final month of an option that a straddle could be paid for by taking a position in the underlying. For example, on November's expiration day, xyz is at 25, and the 25 straddle can be purchased for 1.50. Looking back over the chart of xyz for the last year, we see that xyz almost always moves up or down more than 1.50 between expiration days, so we buy the straddle. Now we put in an order to buy xyz at 23.40 and one to sell it at 26.60. Obviously, the goal here is to purchase/sell the stock at a price that will pay for the straddle and commissions, and give us a very small profit. Now we own a put or call for free and hope for a retracement (which our review of the chart shows is likely). If xyz retraces all the way to 25 we cover and lock in the 2.50 profit and have a free straddle.

    I also wondered if it would be a good idea to put on a butterfly or iron condor or sell a naked straddle on QQQ or some other index to help hedge the risk of the long straddle in xyz.

    Anyway, that's the idea. I'm sure it isn't original, so I would appreciate any insight any of you might care to give. Thanks, and good luck trading.
  2. lindq


    A "simple strategy"? I think not! You've created a complex deal with high costs and no small risk for what? To gain a point or two? And there are many "wishes" and "hopes" in your description, which may or may not come to pass. You have to hit multiple targets, and you have to hit them at the right time.

    Bottom line: If you are a good enough trader to predict the movement of the underlying - which is required to make a straddle profitable - then you are much better off just trading the stock. More certain profits, much lower transaction costs, and a hell of a lot easier to put in place.
  3. Thanks Lindq. :)
  4. Maverick74


    Let me give you some advice. If you want to buy straddles, buy the farthest out month you possibly can and make it a long vega play. Buy the 05 or 06 leaps. Then put flys or condors on the front month every month until the stock starts to move and the vol starts to tick up.
  5. lindq,

    Thanks for the critique. This strategy may very well be flawed, but I'm not sure that it is quite as poor as your response indicates (although it may be). The transaction costs are high compared to some strategies, but at 3-8 dollars per lot per trade, I don't think they are prohibitive.

    Perhaps hitting the targets would be a problem, but I looked at MRK today as an example. It was hitting a new 52-week low, so it attracted my attention. Since December of last year, it has moved at least $2.50 away from the ATM strike each month between the first trading day of the month and expiration day except May August and October. Today it was trading around 41 most of the day, and the $40 straddle could be had for 2.20 (which I believe was actually overpriced theoretically). So it would appear to me that their is a very good probability that MRK will move enough to pay for this straddle between now and expiration day.

    Looking back for the last year, if the ATM straddle could be purchased for $2.25 each month, and stock was purchased or sold when MRK was $2.50 from the strike price, this strategy appears to have been profitable for MRK. May, August, and October would have been the only losing months, and they would have lost about $1 each for a loss of $3. Each of the other months would have made .25 on the initial purchase of the stock for a total of $2 (this is a little bigger profit target than I had originally proposed). There were 6 months that retraced and that provided about $8.50 profit. So the net for the year would have been about $7.50 less about .75 commissions for about $6.75 per contract. Maybe this isn't that great of a return, I'm not sure at this point, but I like the win/loss ratio. If 10 of these positions were put on with a little size each month, it doesn't seem like it would be that bad. And, there is always the chance that the underlying will explode or crash overnight and provide larger than expected profits. I suppose it isn't quite as simple as I thought it was. I think it may merit some further investigation.

    As far as being able to predict the movements of the underlying, I claim no special ability to predict where a stock will move to and in which direction. But it does seem to me that most stocks will move a certain minimum amount in one direction or the other in any almost any given month. If this minimum amount would pay for the straddle, it seems like it might be tradable.

    Anyway, this got a lot longer than I intended. Thanks for you input.

  6. Maverick,

    I find your posts on this forum very helpful and I appreciate your advice. I think I might give this a shot. I will definitely take a close look at it. Thanks for your help.
  7. lindq


    The odds of you making money consistently on straddles are extremely small. Your underlying must make a significant move to overcome transaction and decay costs and provide a profit that is worth the risk. Further, your example points to maximum excursions away from your entry prices. But that is ALL in hindsight. In reality, how do you know that a stock is at a maximum move, and how can you be certain that a move will happen before decay kills your setup? You don't.

    You want to know what stress is all about? Open a couple straddles and wait for them to make a move. NOT worth it. Much easier ways to make money.
  8. There's nothing wrong with the strategy -- it's termed "gamma trading" in floor lingo and you've simply turned the gamma trade into a trade and forget scenario.

    Most gamma trader, myself included, trade the gamma intraday -- typically at sigmas of the daily range of spot volatility.

    Roll over and forget buying LEAPS straddles, there's no gamma in 'em. Conversely, there isn't any theta loss either, but very little leverage. Only buy a LEAPS straddle if you're intent on buying vegas, not gamma(specifically).

  9. Check out an option book by Gallagher w/c details trading ATM straddles and its expectacy. As a previous poster just said, you are looking to gamma scalp and there a lots of posts here about it. You can recreate the phantom straddles Gallagher suggest and run them in an excel and see what stocks will this strategy work. Trading straddles is like gun control or abortion, a lot of bipolar opinions. Lindq has a point about just trading the underlying but it doesn't address micro-risk. Traders who succeed in this have good intuition as to when to put it on while the ones who fail have this " that straddle is cheap I am going to buy it and hope it explodes tomorrow" mentality. Which brings you back to lindq's point. To do this you have to at least stick your neck out as to the direction or magnitude of the move. Once you develop that, with all due respect to lindq, you can do much better than trading the underlying.

    Good luck.

  10. Riskarb,

    Thanks for the input. I have been reading about gamma trading on this board, but I'm not completely clear on the actual logistics of this type of trading. I also don't know what a sigma is. If you would like to explain the details of what you do, I would be very interested. I may have to look for a good book, my books by McMillan don't seem to detail this type of trading - at least not using this vocabulary. I hadn't considered doing this intraday, because I thought the spread would eat up most of the profits. I am going to take a look at it though. I could really use a good intraday strategy. Thanks again for the help.
    #10     Dec 1, 2003