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 data**This 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**