Last week's article tackled a topic all options traders face. How do they begin to evaluate a supposedly successful trade strategy someone mentions to them? My dinner partner had mentioned that his brother had been successfully trading a strategy achieved by buying long stock and a long put on that same underlying. The discussion had assumed that the brother's intention was to hedge stock he held against a downdraft, with the long put placing a floor under the loss he was willing to accept. A first look at the pros and cons of the situation was built around that premise.
That premise had appeared to be the right one for this trade due to the few details the dinner partner provided, but what if those details and the subsequent supposition were wrong? Below, you'll find a graph of the position that the dinner partner's brother was likely employing, brought forward from last week's article, followed by a different strategy that he could have been using. Showing both allows us to see the differences.
Long Stock Plus Single Long ATM Put:
What if the dinner partner's brother was employing an entirely different strategy, composed of the stock plus two long puts?
Stock Plus Two Long At- or Near-the-Money Puts, as of September 3:
This is also a "long stock plus long put" position, but there's a major difference in the construction and the intention of the strategy. Instead of buying a single LEAP put with the intention of hedging against downside risk, this strategy adds two OCT 14 near-the-money puts with the intention of capitalizing on a big move either direction. Because this trade is being illustrated only 44 days to expiration, the trader would have to believe that AAPL stock could move above about 109.09 (plus the commission cost) or below about 90.94 (minus the commission cost) within those 44 days. Otherwise, the price falls within that sea of death, where the expiration line sinks beneath the flat-line area. The maximum loss of this trade will be at the $100 strike at expiration, at the bottom of the sea of death, and that loss will be about $901 plus commissions.
How likely is it that AAPL will swing high enough or drop low enough before OCT expiration to make this trade profitable? Note: remember that these Options 101 articles are roughed out and edited before publication, so prices are not up-to-date. These discussions are not about specific trade suggestions, but rather are educational.
Daily Chart of AAPL, as of 9/3/14:
The two short red horizontal lines mark the approximate locations of the upside and downside expiration breakevens. If the stock bounces back up from the support of the lower channel trendline, it does appear that AAPL could hit the upper channel boundary before the OCT expiration, although the stock's price might be facing considerable resistance if it does hit the top of the channel. If the price continues much lower, it will be breaking through the lower boundary of the rising price channel. A typical downside target would be a drop about the width of the price channel in which AAPL been traveling. That would bring AAPL's price to or near the downside breakeven. However, it might find support near $90.00 if that action should occur.
However, if AAPL moves big enough in a soon-enough time frame, the trade would be profitable before those expiration breakevens are exceeded. Theoretically, a quick climb above about $106 (plus the cost of the commissions) or below about $93.70 (minus the cost of the commissions) would render the trade a profitable one. The trader employing this strategy would need to be confident that AAPL would continue to move in the direction that had produced the profit, however, to hang on. Therefore, this trade is one in which the trader expects much price volatility and expects it to occur over a relatively short period of time. That volatility is needed to overcome the decay from the mostly extrinsic value in the two purchased puts. The expansion in price volatility that the trader expects should be coupled with the trader's belief that implied volatilities are cheaper than they will be in the near future, rendering the bought options relatively cheap.
Does this seem likely to be a trade engaged in month after month with the expectation of a relatively smooth profit-and-loss line, as my dinner partner claimed his brother was doing?
Nope. Situations certainly set up at times to make this trade a profitable one. This trade setup could even, at a stretch, be considered a hedging trade against a long-term long stock position. This is a synthetic straddle.
Here's a look at a more traditional straddle, composed of put(s) and call(s) at the same strike.
Traditional Straddle as of September 3:
This more traditional version of the straddle requires less of an outlay, of course, since the long call plus long put combination is cheaper than the long AAPL stock plus long puts. Delta and theta are both negative, with theta getting more negative as expiration approaches and price begins to fall into that sea of death. This trade's vega--the measure of how much it benefits by a rise in implied volatilities--is twice that of the synthetic straddle. That's a benefit if implied volatilities expand, and that benefit is shown by the position of the "today" curve, showing the profit-and-loss over the short-term. This trade theoretically breaks even if there's a quick move above about 101.50 plus the cost of commissions or below about 96.90 minus the cost of commissions. However, the trader would have to be confident that price was going to move further in that profitable direction or the "today" line would sink toward the expiration line, into the sea of death that still stretches below 101.50 and 96.90.
That dinner partner's comment has stimulated a discussion of more than one strategy: a use of puts to hedge against loss with a long stock position, the possibility of creating a collar by selling calls against that long stock-long put position, the creation of a synthetic straddle, and a look at a more traditional straddle.
The hedge and the collar positions might be positions engaged in month after month, and last week's article can be reviewed for some of the pros and cons of each of those strategies. The straddle, whether synthetic or the more traditional form, can be a profitable strategy in some market conditions. It appears less likely that the dinner partner's brother engages in a synthetic straddle trade month after month with sound results if he's using the same underlying. That skepticism is because this trade requires certain conditions to be met in order to be profitable. Those include options that are relatively cheap and the expectation that the underlying's stock will move big and implied volatilities expand. Some inexperienced options traders might think that the period immediately before an earnings or other expected announcement would be a good time to enter such trades since big price movements might be more likely after such developments. However, many find to their dismay that volatilities have been rising into the announcement, rendering options expensive. Market makers are already pricing in the expected price movement. That volatility then collapses after the announcement unless the move is even more than is typical for that stock after such announcements or is expected for this particular event.
However, if the more traditional call plus put straddle is employed, it is usually possible to scan for stocks with implied volatilities that are lower than historical volatilities by some measure the trader feels is appropriate--perhaps in the lower 1/4 to 1/3 of the historical range of volatilities for that underlying over the previous year, for example. The identified underlyings' price chart could then be examined to determine whether a big price move might be expected. Straddles could be entered if the trader felt the conditions were right. One argument against this tactic would be that the trader would likely always be working with an unfamiliar underlying. While that can prove problematic for options traders, it can be more so for those employing the stock-plus-two-puts position of a synthetic straddle. Why would anyone want to own stock on multiple unfamiliar underlyings?
There's more to examining a supposedly sure-fire strategy that you've heard about during a dinner conversation, of course. If your interest has been piqued, however, your first task is to identify exactly what the trader has been discussing, the reasoning behind the trade, and the conditions in which it would flourish or languish. How much money is required to undertake the strategy?
Only then is it time to even go so far as to do some back-testing, follow some simulated trades, or try the trade with a smaller-than-normal size if you're the kind of trader who has no patience with back-testing or simulated trades. You'll want to know how smooth the profit-and-loss results are over a period of months before you decide whether that trade is profitable or workable for you. A strategy could make money over a long period of time--say 30 months--but that profit could be made by one or two huge winners while most periods saw one month after another of losses. Could you really wait out six months of losing trades for that huge winner or would you take five months in a row of losing trades and then abandon the trade without ever capturing one of the big winners? Does the trade require that you be available several times a day to adjust, and you're working full-time with many conferences that can't be interrupted to check on your trade? There's lots more to know than whether the trade is making someone else money. You're not someone else.