Take the Fear Out Of Options With a Straddle

Posted By Barry Brush |  Subscribe in a reader | Comment 2
2DIME’S INVESTOR NOTES
Monday, January 14th, 2008
 
 

A Simple Trade to Take the Fear Out Of Options

How many times have you selected a stock, evaluated it, chosen an option strategy and entered the trade only to have the stock move against you?
 
When I first started trading options, this seemed to happen to me all the time. It seemed easy to find great picks. I would buy call on a breakout and watch my investment soar often for a gain of 100% or more.
 
As my mood soared with the stock my emotions took over and I would start imagining all of the material treasures I would now be able to purchase. The impish voice of greed would begin talking to me and I would ride the play higher and higher to greater returns never taking any off or moving up my stops.
 
The next market cycle or price wave would kick in as more savvy traders took some profit off the table. My greed would tell me the play still had room to grow; but my fears began to overcome my hopes as the trade inevitably descended below a 100% rate of return. My fear would approach panic as my paper profit evaporated.
 
I would stay in the play until I was back to zero figuring that some how it would revisit 100%. I never sold until I was afraid I might loose everything I’d put at risk. This Battle inside my head between the emotions of Greed and Fear went on until I eventually paid for the luck I had had in my first six months of trading by bringing my account balance back to where it had started.
 
If any of this sounds familiar, you are on the right track. If you are there now, you have probably figured out that you should do something different. If you don’t know what it is that you aren’t doing, I suggest that you begin a trading journal. Who knows, perhaps the weather or what you had for breakfast may be adversely affecting you. More likely than not, it is only greed and fear at play.
 
If you are new to Options, Let me suggest a simple fool proof trade to get a grip on your financial future. The cool thing is that with this one, there is no room for greed or fear. All option traders should be able to make money if the underlying stock changes its price. The only constant is change and change is good. Up or down, it is good. We are going to expect and profit from change. We are not going to buy and hold anything. You can’t buy anything with paper profits, except maybe a failed mortgage company. BO! FA! FA! FA!
 
This trade is not about being right or wrong, it is about winning. You should be able to win with it 85% of the time, while minimizing your risk to about a 15% per trade. There are three steps to it.
 
First, find a stock that you think will move significantly in the next three weeks. You can find one based upon News, Rumor, Earnings or perhaps one of those scanners a lot of sites promote. It can be a good event or a bad event. It just has to be important enough to prompt a move in the stock.
 
Second, simultaneously buy a put and a call on either side of the at-the-money strike price. (Option strike price closest to the stock price)  Try to have your play in place three weeks prior to the upcoming event. Purchase options with approximately 3 months remaining until expiration. There, you’ve “straddled” a price point of an underlying stock. You now have the right but not the obligation to buy or sell 100 shares of your stock pick at the same price, the strike price.
 
Third, relax, don’t worry – make money. If your “event” causes the stock to move in advance of the event or at the event it doesn’t matter. Give it some time, perhaps as much as a week. If its good news and the stock goes up, your call will bring a profit WHEN YOU SELL IT. Or if its good news and the stock price falls because it wasn’t good enough, your put will make you smile WHEN YOU SELL IT. You can sell at a profit or put on a stop at a profitable level. That’s up to you. I personally like to sell. I’m a “now” kind of guy.
 
A normal expectancy would be for the profitable move to yield twice as much as the other side looses. Two to one odds are the norm. One quick note: After you capture your profit, you might hesitate before unloading the opposite option.(s) Often a fast moving stock will reconsider its direction and retrace a bit, giving you the opportunity to recapture some of the initial decline on the loosing side that occurred as the stock made its initial move.
 
A fourth step is a remote possibility if you have picked a mover; but I’ll cover it any way. If nothing happens, nada, no movement, zero; sell both sides and go shopping for another trade. You will most likely be able to limit your loss to around 15% of your initial investment. Say the “Straddle” cost you $100 for the Put and $150 for the Call your total investment would have been $250 and your total risk 15% or $37.50. I’m not a mathematician but you could probably loose on 7 out of 10 of these and still make money.
 
No Greed, No Fear, No Worry. I’d much rather win than be right or wrong. Wouldn’t you?

Cheers, 2Dimes / Barry Brush
To contact me send an email by using the Contact form (link above) and Tate will make sure I get it.  The best option is to submit your comment to the blog here )

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Comments on Take the Fear Out Of Options With a Straddle »

January 16, 2008

Elias Rorris @ 8:04 pm

THERE IS ONE BIG PROBLEM with this strategy.
Because of the upcoming event, the options are expensive. (high volatility). Upon completion of the event, the volatility drops thus rendering the options cheaper. If the stock does not move a lot, you will lose money.

Barry Brush @ 10:50 pm

“Right On! The problem is there, so beware. You don’t put on a straddle unless there is a HIGH probability of movement. If it doesn’t move; which I addressed, you will loose: but the strategy includes your attempt to limit it to no more than 15% of your invested premium with an exit strategy. Thus you retain 85% of your high probability investment for another day. Good thinking to be concerned about limiting your risk in the event of non-movement.” P.S. I know some option traders who instead of exiting a play over earnings; enter a short term straddle until the report is anounced. Afterwards, they trim back the hedge so they can see around the bends in the road ahead. Thanks for reading. Cheers, 2dimes