Today’s Trading Lesson From TradingMarkets

There’s a saying on Wall
Street about no free lunches, but if you’re an options trader, you
might be able to walk away with a “gift,” courtesy of Wall Street.
The gift that I’m talking about is a position trade that Kevin
Haggerty calls a synthetic straddle in some of his morning columns. From
my days on the options floors of the AMEX and the PSE, I’ve always referred to
it as a “gamma position.”

In essence, the synthetic straddle is nothing
more than a “regular” straddle. As a trader with a basic understanding of
options, you know that this type of position is quite simply a bet on future
price movement, or volatility. For those unfamiliar with general option
strategies I would suggest looking over

Tony Saliba’s Option Workbook.

We will give a brief definition of the risk and
reward characteristics of the straddle in the following text, but this article
is geared for those of you already familiar with the mechanics of how puts and
calls work, who would like to better understand the conceptual framework that’s
involved in a slightly more involved but potentially lucrative trade.

An options straddle
is comprised of an equal number of purchased call and put contracts with
the same expiration date and strike price. The object of “buying premium,” as
this is sometimes referred, is a trader’s way of “making a bet” on future
volatility in the product of their choice. There are different types of
volatility, but to keep it simple while learning the broad strokes of a new
strategy, we will be referring to the underlying stock’s volatility when we make
further use of this term. When contracts are bought, it can be thought of as a
race against time. Ultimately, options either expire worthless, or in the money.
As buyers of premium, such as with a straddle position, our initial bet when
making the purchase is for one side of our position, either the call or the put,
to go dramatically in the money. At expiration, barring a “pin” at the strike
which we established our trade, we will end up with one contract that is
worthless, while the other one has some intrinsic value.

Intrinsic value
is how much a contract is worth at the close of every option trader’s favorite
day, that third Friday of the month. With intrinsic value being a function of
how far the closing stock price is away from our strike that we
purchased,…well, it doesn’t take a rocket scientist to know that we’re hoping
for a “moonshot” of price in either direction in the underlying stock.

A simple example of a regular straddle position
would involve purchasing the XYZ 50 level straddle for 2 points with two weeks
until expiration, and the stock at 50. It doesn’t matter in this case how much
we paid for the individual components (the calls or puts). We are only concerned
with the total outlay of capital, in this case 2 points, or 200 bucks a
contract.

If no action had been taken by our buyer of
premium until expiration Friday, and the stock so happened to close at 55, we
would then have a very happy straddle buyer. His initial 2 point outlay would
now be worth 5 points. The calls would be $5 “in the money,” the puts worthless,
and his pockets lined with an extra 3 points, after accounting for the original
admission price of 2 dollars. Not a bad ride, but there are more creative ways
to play a straddle that can ultimately lead to even better results, while
reducing initial risk in the process. Are you ready?

With a synthetic
straddle, we have the opportunity to scalp stock that is built in to
our original position. Instead of using an equal number of call and put
contracts that simultaneously hedge the initial directional bet (assuming “at
the money” options ), we use a combination of stock and options. The “synthetic
straddle” also requires this key ingredient of volatility, and without its
participation it must be stated that both the regular and synthetic strategies
will test your patience, as well as your trading account.

Unlike its cousin, the synthetic is used mostly
by market professionals. One of the reasons for this might be that synthetics
require holding stock overnight, rather than just options, and as such, the
margin required can be considerably more of a financial burden if one isn’t
adequately capitalized. For every negative there is a positive, and with our
synthetic, one of the privileges is the flexibility to scalp the underlying
stock against our option contracts. Huh?? In establishing the synthetic, the
trader has one of two choices (the ratios below reflect a synthetic straddle
looking for movement or volatility, but with no initial directional bias when
using at-the-money options and stock):

1. Buy “X” amount of Put contracts, and hedge the
   initial directional price risk with a Long stock equivalent equal to 1/2 of
   the number of contracts purchased. For instance in our XYZ example, with the
   stock at 50, we could buy 500 shares of the underlying XYZ, and simultaneously
   buy 10 of the 50 level Puts.
2. Buy “X” amount of Call contracts, and hedge
   this directional risk into a synthetic straddle by simultaneously “shorting”
   1/2 as much stock. In this case, using the same numbers as above, we short 500
   XYZ as we purchase 10 of the 50 Level Calls.

In a perfect world, the choice between the two is
something for academics to discuss. In the real world with traders having to
deal with margin requirements, uptick rules, and potential “hard to borrow”
stock issues, I’d say most traders have a tendency to use long stock versus puts
when trading equity issues. However, if you’re trading index proxies such as the
semiconductors (SMH),
the Nasdaq 100 (QQQ),
or the Dow Jones (DIA),
then most all of the above listed concerns go the way of the dinosaur and you’re
free to flip a coin.

The ratio in both of these choices effectively
neutralizes directional risk (initially), because our 10 contracts, when “at the
money,” have approximately a 50% chance of finishing “in the money,” or “out of
the money,” by expiration. At expiration, if the contract is “in the money,”
then the put or call acts just like stock, and would be assigned a 100% figure,
or “delta” (the rate at which the contract moves with the underlying on a point
by point basis). If the contract finishes “out of the money,” it would be
assigned a zero delta.

So for every day that exists between “the now,”
and expiration, the contract would have a delta percentage falling somewhere
between 0 and 100%. This is why this ratio works when the traders intentions are
to capture “a move,” but doesn’t want the initial directional risk, but only the
“premium or volatility risk.”

It is the stock component and initial ratio that
gives a trader the ability to potentially trade the position’s stock for
scalping profits, during the interim, prior to the option’s expiration. Don’t
worry if you’re still confused by how this all works, as our example trade is a
very good position for showing how uncomplicated and easy this can all be. For
now, the one other point that I would like to bring up, before we go into our
trade, is your “net stock position”.

The ability to scalp stock is dictated by the
“net stock position.” With equity options one contract is the equivalent of 100
shares of the underlying. For instance, with our XYZ example, if we bought 10 of
the puts this would be the equivalent of being short 1000 shares of stock. If
the initial synthetic consisted of 10 puts and long 500 shares of XYZ as our
hedge, in effect we will still be short 500 shares…that is if the underlying
stock decreases in price below the strike, before expiration. At expiration, in
this case we would exercise our puts, 10 contracts remember, thus establishing a
short position of 1000 shares.

But remember, we had already purchased 500
shares, so our net position is short 500 XYZ. For our position, this translates
into a “very good thing.” The further below our strike price the better, because
we now get to buy stock at a much lower price than where we effectively shorted
it (strike price minus the initial premium). This stock purchase will average
our cost of long stock (stock bought now plus the initial purchase at time
synthetic was put on). On the other hand, if the stock did a “moonshot” to the
upside we would be long 500 shares for the ride, minus our now worthless premium
outlay.

For simplicity’s sake let’s say our stock XYZ
gapped up 10 points on a takeover bid. In this case we would stand to profit by
$5000 (500 * 10pts.) minus the premium paid for our straddle. We would also now
have to sell 500 shares of stock, at much higher prices, to rid ourselves of any
further directional risk, in what became a very profitable synthetic straddle
trade. Pheeww!!

OK, so now we’re ready to get into the real meat
and potatoes of the synthetic. Remember how, in our very classic example XYZ,
that the investor waited until expiration to take action on his call and put
position? Well, with our friend the synthetic, we turn off the snooze button and
try to take advantage of the volatility that takes place over the life of our
position. Instead of waiting around for two weeks to expire, and hoping that an
exceptional move has taken place, and then “do the stock,” we take off our golf
spikes, put on the trading jacket, and scalp stock against the position before
expiration!!! By successfully scalping stock against our position, we whittle
down the potential “decay,” or premium risk that we have, since we did initially
purchase contracts.

Below, we’ll be going through a synthetic
straddle in the Dow Jones ETF, the (DIA).
In reading through the trade you’ll see our thought process, how the position
evolved, and ultimately decide for yourself just how aggressive you want to be
with the synthetic straddle. Are you a buyer yet? Maybe after finishing up you
will be, as you might decide to add your own rules that fit your own personal
style of trading.

As stated already, straddles, and their synthetic
cousins, are bottom line, all about making a calculated bet on the future
volatility of the instrument of our choice. Just like when one trades stock, a
well designed trading plan includes contingencies for entering and exiting based
on technicals and proper risk management. We’re not here to tell you how you
have to trade, but in the following example you will see one way in which the
synthetic straddle could be traded very profitably over the course of a three
week period. What you do after that is all up to you, as the clock is still
ticking towards yet another expiration!!!

In our trade example we are going to dynamically
“scalp” our synthetic straddle using a combination of technical analysis on both
the VIX (cboe volatility index), and the DIAs.

 

In the above chart we have a daily price graph of
the CBOE Volatility index, or “VIX” ($VIX.X)
as it is most often referred. As with equities, and indices, the ability to use
technical analysis is one way of gauging probable short term future movement on
this index. On March 3rd, with three weeks left until the next options
expiration, the VIX was showing a potentially oversold condition from which it
could bounce. Price action had dropped down to the recent lows of the VIX’s
trading range (shown by green horizontal lines), which at the time was also
testing a 20-Period, 2 Standard Deviation Bollinger Band.

The VIX, which measures “crowd sentiment” of fear
and complacency, was demonstrating some complacency on this day. When the index
is establishing relative lows, like on March 3, it essentially underscores the
point that investors are not “buying protection” for their equity positions. The
VIX’s overwhelming tendency is to move contra to equity indices, or proxies,
such as the DIAs, SPYs, and the QQQs. Since “the crowd” is usually wrong at
extremes, the VIX, which was now potentially “oversold,” was indicating a high
probability trade opportunity. When a trader wants to execute a trade based on
“market volatility” the purest way to do this is through the use of equity index
options, like the ETFs. We can’t buy the VIX per se, but as I mentioned, it is
directly correlated to the price action in the market indices.

In our trade we looked to take advantage of the
VIX price action by using the Dow Jones Industrials ETF, the DIA. For this trade
it was decided that the Synthetic Straddle was the best way to position
ourselves for a “pick up” in volatility. Although we will normally associate low
VIX readings with a potential sell off in equity indices, we decided that a
volatility bet, without having to chose a price direction, was best suited for a
more conservative trade. To execute this position we would therefore put on the
Synthetic Straddle, “delta neutral”, using At-The-Money options.

In the above 60-Minute chart of the DIA, one
could have established the Synthetic Straddle by purchasing the At-The-Money 80
level Calls for 1.75 versus approximately 79.60 stock on March 3rd, during the
first 30 minutes of trade (due to a technical issue this could not be labeled,
but can be seen as part of the first price bar on our trade date). We used the
Calls in this example as the uptick rule that effects equities is not a problem
for trading ETFs such as the Diamonds. Therefore, to establish the delta neutral
synthetic we need to buy calls and sell stock at a 2:1 ratio (remember our 50%
premise). In the vein of simplicity, let’s say 10 of the 80 level (strike) Calls
were used vs. 500 shares sold of the DIA. Now we need “something,” namely
underlying volatility in the Diamonds to “pick up” for our trade to begin to
work effectively.

As fate, or the market gods would have it, we put
on our volatility play at a very good time. Looking at the VIX chart once more,
we can see that the volatility levels did indeed reverse, trending higher from
our original entry point on March 3rd. By March 12 you could honestly “smell the
fear” that was once more prevalent in the market place. I personally was hearing
things like, ‘ we’re going to 60 in the VIX!!’, and ‘equities are definitely
going to break the October lows.’ Scary, eh? You bet, and that’s why it was the
perfect time to “shore up” our volatility position.

On March 12, with the VIX ‘now going to 60’, we
looked to see what was really happening. Price levels in the VIX had gone up
over 30% since March 3, but just as important, we were showing excellent
technical signs that a potential reversal was imminent. March 12’s action
pierced the recent trading range resistance levels, as well as a longer term
trend line extending from the July to October peaks. This also happened to be
the first price action that was penetrating our Bollinger Bands. As a trader who
“bought on the cheap”, you knew that it was time to once again execute.

Referring back to our price chart of the DIAs,
you can see what had happened to our underlying stock position during the
explosion in volatility. The DIAs had retreated into a solid downtrend, and
giving us an opportunity to hedge our original Synthetic Straddle. With prices
down to nearly 74, our 80 Calls were “essentially worthless.” Even with the
explosion in volatility (which has the effect of pumping up option prices),
because the index had moved considerably away from our point of entry, and time
had elapsed (only 7 trading days left until expiration), we were the “not so
proud” owners of what appeared to be worthless Calls…or were we?

With the Calls trading as “worthless” or “rip
ups” (something I’ve always called them when they’re offered for .15 or less),
we could assign our Calls a delta that was fast approaching zero. This is a key
point, and how the dynamic hedging of our straddle works most effectively (btw
there are plenty of software vendors that can keep real time “greeks” for option
positions). As our premium outlay was lost in this case (from 1.75 to under .15)
and the market lost ground, our position had actually gained ground very
effectively. Remember, we still had a position of short 500 DIAs from 79.60. As
Kevin Haggerty likes to say, “It’s too easy!!!” We now needed to take action!

Although we only show the 60-Minute price chart
here (which does show a nice doji like reversal bar off the bands), using the a
la Haggerty 1,2,3 reversal strategy on the 5-Minute chart, we had an excellent
trigger to “buy in” our short 500 shares somewhere between 74.65 – 74.85. Using
the midpoint, the stock scalp was worth 4.85. Translated into net profit
results, since our “bet” cost us 1.75 to start on a 2:1 ratio, we now had a
“worthless Call” for the remaining 7 days, established for a credit of
approximately .70. Now, regardless of what the market had in store for us, we
stood to profit by at least .70 or $700…and oh boy, look at what happened
next!!!

Can you say “moonshot” to the upside? “Oh baby”,
is right. This deserves another, “It’s too easy.” In our trade, by keeping to
the VIX as our guide for exiting, and also for the practicality of keeping it
simple, the trade would have worked itself out into a “monster trade.” As the
DIAs reversed, and subsequently rallied from “the abyss” of panic, our position
which was comprised of being long “worthless” Calls (for a credit), turned into
something worth a whole lot more.

By expiration day, with the DIAs closing at
85.13, and the VIX finally reversing back down to the “lower band” of support,
our 80 Strike Calls were now deep In-The-Money, and worth over 5 points. Add in
the credit of .70 on the 10 Calls, and you’ve got a trade worth $5700. Remember
to send a thank you note to Mr. Market, but congratulate yourself, by now being
able to go out and get another “gift.” Thank you Wall Street!!