Trading Option Straddles and Strangles: Part 2
In the previous article we introduced two non-directional option
strategies: straddles and strangles. We’ll now discuss when to use
these strategies, and how to evaluate their potential for success.
Long straddles and strangles are useful tools when you think that a stock
will undergo a large move, but you’re not sure whether the move will be
up or down. Short straddles and strangles are simply the opposite side
of this trade, and are essentially a bet that the stock price will not
change significantly before expiration.
Some traders like to use the long version of these strategies when a company is announcing
earnings or introducing a new product to the marketplace. However, it’s
always hard to know how much of the news is already “priced in”, i.e.
reflected in the current price of the stock. So how can we tell if the
change in stock price is likely to be large enough for a long straddle
or strangle to be profitable?
There are at least three ways to gauge our chances of success with a straddle or strangle:
- Use a quantified, back-tested strategy.Obviously this is our preferred method. Developing a well-defined
strategy with precise entry and exit rules and then back-testing that
strategy with reliable data across a variety of market conditions gives
us an excellent perspective of how the strategy has performed in the
past, and therefore provides some reasonable (though certainly not
infallible) expectations of how it will perform in the future.The
challenge here lies with the “reliable data” aspect of back-testing.
While there are many, many sources for high-quality historical stock and
ETF data, good options data is much more difficult to obtain. This is
partly due to its volume (consider that a single stock may have dozens
or even hundreds of strike prices for each of several active
expirations), and partly due to its transience (most traders don’t care
about the price of an option that expired three years ago). - Use stock prices as a proxy for option prices.If you don’t have access to option data, you may be able to gain some
insight by looking at historical stock prices. With AAPL earnings being
announced this week, you may have thought that last Friday would be a
good time to purchase a straddle using weekly options. However, the ATM
straddle had a price of around $36 on Friday, which is 7.2% of AAPL’s
$500 stock price. Recall that for a long straddle to be profitable, the
stock price needs to move up or down by more than the cost of the
straddle. Assuming you’d like to make at least a 10% profit on your
trade, you could check how many times AAPL has moved by 8% or more
during earnings week. Over the past three years, it’s happened 5 out of
12 times. Do you want to place $3600 on a bet that’s been a winner less
than 50% of the time in recent years? - Apply an option pricing model to current option dataThis is the most complicated of the three solutions, but is not as
intimidating as it sounds because your trading platform will do most of
the work for you.Theoretically, the price of an option is determined by a
number of factors. The four most influential ones are:- Price of the underlying stock
- Strike price of the option
- Time until expiration of the option contract
- Implied (expected) volatility of the stock price
The actual option price and all the values above except implied volatility
are easily obtained. Because we have all the other elements, we can
algebraically solve for implied volatility, which in turn allows us to
calculate delta (one of the option Greeks) and the probability that the
option will expire in the money (ITM). All platforms will have a way to
report delta and the other Greeks. Some platforms will also report the
probability of the option expiring ITM. For example, here was the weekly
option chain for AAPL as of Friday, January 18th, as shown on TD
Ameritrade’s thinkorswim platform. Calls are on the left, puts are on
the right, and strike prices are in the blue section in the middle.
Notice that the value of delta is quite close to “Prob ITM”, which is the
probability that the option will expire in the money. Therefore, delta
is a reasonable substitute for probability of expiring in the money if
your platform doesn’t provide the latter value.How does that help us? Well, we know that the 500 strike straddle would have cost just
under $36 last Friday. Therefore, to profit we need AAPL to move by more
than that amount, so let’s say we’d like at least a $40 move. The
current AAPL price of $500 plus a $40 move would be $540. Looking at the
option data above, we see that the 540 call has a 17.68% chance of
expiring in the money, i.e. there’s a 17.68% chance that the price of
AAPL will be above $540 by expiration. Similarly, the OTM option that is
$40 below the current stock price is the 460 put, which has an 18.49%
chance of expiring in the money. Therefore, the combined wisdom of the
marketplace, as encapsulated in the price of the options, is that
there’s less than a 20% chance that the price of AAPL will move
sufficiently to make the straddle profitable.
Obviously the market
is not always correct, and sometimes the market participants get
surprised. Would you be willing to bet your money that this is one of
those times?
You now have several tools to help you evaluate whether a straddle or strangle is likely to be profitable. The
same tools can be used whether you’re considering a short position or a
long one. We hope you have found this information helpful!
Click here to read Trading Option Straddles and Strangles: Part 1