Option Investor
Market Updates

One way to trade a straddle

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Yesterday on PremierMarkets.com I highlighted a straddle trade on the Securities Broker/Dealer Index (XBD.X) as I felt this index was at a nice short-term pivot point and that this index could break considerable in either direction, up or down. Straddles are popular among traders that aren't trying to guess market direction, but simply looking to capitalize on a move they believe is coming. This is much like a pressure cooker. You can see the pressure building, but just don't know who is going to win short-term (bulls or bears). Today, the break looks to be coming to the downside with the XBD.X down 2% and is second only to the BTK.X in current percentage loss. Here's how I'd look to trade this break considering current market environment.

Strategy

Yesterday at 10:30 EST I thought the 520 strike for both a put and call would be an appropriate level for June expiration. The symbols were (XEBFD) and (XBERD). The reason I liked the June expiration is so that I would hold the "losing trade" for a period of time and then look for a recovery in the losing trade to end up with a net profit between the two. Here's how it would currently be working if they were both purchased near $40. The total outlay for this trade for one contract each of the put and call would have been $8,000. $4,000 for the call and $4,000 for the put (they were actually a little less, but lets work with round numbers). A straddle trader usually enters a straddle knowing that one of the options will result in a loss. The key for trading a straddle is to simply know what you're total cost is and what you're break-even total would be. From the above information, I know that If I hold each until expiration, then the XBD.X needs to trade below 480 (520 strike - $40 option) or trade above 560 (520 strike + $40 option) to result in a break- even or profitable trade.

Plan

Ideally, the XBD.X will run straight down to the 480 level and I can close my puts out for a nice gain and then look for the XBD.X to shoot higher

Broker Dealer Index Chart - $4 box scale

The point and figure chart is very useful to an options trader. We can see that a pullback in the XBD close to the 480 level is quite possible from an institutional perspective. We also can see that the vertical count gives us a bullish price objective of 628 = ((17*3)*4)+424. If the XBD were to trade the 480 level, I'd look lock in profits on the put option and then hold the call position with a bullish price objective of 628 as a possibility. The reason we went with a straddle yesterday was that the bullish percent charts for some indexes were at "overbought" levels and a pullback would allow for some profits to be had on a pullback, but we also wanted the calls because of the extreme bullishness longer-term we were seeing. Buy extending option expiration out until June, we allow ourselves time for some bullishness to continue in the XBD.X.

Jeff Bailey
Senior Market Technician
www.PremierMarkets.com

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