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« Why a Gold Standard? | Main | Randgold Resources Limited: Up 19.23% today! »
Monday
Nov032008

Long Straddle Options Strategy – “Double and Quits”

The following is an options trading strategy that we have been considering, based on the long straddle strategy. We think it could be effective in these volatile times, so we are putting it forward for disscussion and would appreciate any comments that anyone has on the ideas, both positive and negative!

Theory


- Option contracts always have a certain amount of value in the market before expiration, regardless of price of underlying assets, due to the time premium built into a contract price
- In a volatile market, stocks jump about greatly, and therefore the calls and puts on these stocks jump around even more, often doubling in less than a month.
- If an equal amount of capital is put into a call and a put contract, which move inversely of each other, with the same underlying asset, then the volatility of the option prices means that one will rise dramatically when the other falls.
- If a combination of call and put options are selected that are volatile to the extent that one will double in around a month, then the option that doubles is sold, this reduces the traders cost adjusted risk to zero.
- The remaining (losing) contract is then sold on the market for whatever the current market price is, even if that price has decreased greatly from the original purchase price. The money generated from this sale is the profit on the trade.


Note: Since profit margin is small, trade must be designed so that the commission costs do not reduce net profit. E.g. buying 10 puts at 0.10 and 10 calls at 0.10 (total invested = $20. commission estimated $50) would incur large commission costs relative to the size of the trade.

Step by Step Theoretical Plan


1. Company, contract details worked out and trade identified.
2. Calls, Puts are bought virtually simultaneously on contract with expiration about 3 months away.
3. Immediately after, sell orders placed for calls and puts at double their purchase prices.
4. Once sell order is filled for one of the options, other option is sold at market to return the profit for the trade.

Note: If at any time the market value of both positions exceeds (by a decent amount) the initial capital placed in the trade, both positions can be sold before one doubles to return a (possibly smaller) profit in a shorter space of time. E.g. $10,000 in total is placed into the trade, and at a certain time the calls are trading for a value of $7500, and the puts have a value of $3000, then both posistion could be sold to bank a $500 profit.








Practical Example 1


Company: AEM – Trading at $50.00
Purchased October 2008 options on 15th August 2008
$10,000 invested over both positions.

AGNICO EAGLE MINES LTD COM OCT 18, 2008 $ 50.000 CALL
(Bought for $7.50. Sell order placed at $15)

AGNICO EAGLE MINES LTD COM OCT 18, 2008 $ 50.000 PUT
(Bought at $4.50. Sell order placed at $9)

AEM stock price was very volatile, and both options came very close to reaching their sells. Then:

On September 12th, the calls rose to (and later past) $15, which would have triggered a sell.
Calls Sold at 100% profit generating $10,000 in cash.
Gross Profit/Loss = Zero
Net Profit/Loss = -$75.00 (estimated commission costs of trade)

As soon as the calls were automatically sold at 100% profit, the puts would have been sold the same day at market.

The puts were trading at just over $0.80 that day.

Therefore the sale of the puts would have generated $888
Calls Sold at 84% loss generating $888 in cash.
Gross Profit/Loss = $888.
Net Profit/Loss = $813 (after estimated commission costs of trade)
Achieved in a month.

Long Stradle Options Strategy – “Double and Quits”


Practical Example 2


Company: AEM- Trading at $45.00
Purchased October 2008 options on September 10th 2008
$10,000 invested over both positions.

AGNICO EAGLE MINES LTD COM OCT 18, 2008 $ 45.000 CALL(AEMJI: OPRA)
Bought for $5. Sell order placed at $10

AGNICO EAGLE MINES LTD COM OCT 18, 2008 $ 45.000 PUT(AEMVI: OPRA)
Bought at $4. Sell order placed at $8.

AEM stock price gained in the next few weeks.

On September 16th, the calls rose pas $10, which would have triggered a sell.
Calls Sold at 100% profit generating $10,000 in cash.
Gross Profit/Loss = Zero
Net Profit/Loss = -$75.00 (estimated commission costs of trade)

As soon as the calls were automatically sold at 100% profit, the puts would have been sold the same day at market.

The puts were trading at $0.50 that day.

Therefore the sale of the puts would have generated $500.
Puts Sold at 90% loss generating $500 in cash.
Gross Profit/Loss = $500.
Net Profit/Loss = $425 (after estimated commission costs of trade)
Achieved in less than two weeks.

Long Stradle Options Strategy – “Double and Quits” 2


Downsides


No plan is perfect, and this one is certainly far from it with a number of downside risks.
The best way to explain the threats to the trade’s success is by the following scenarios that would result in substantial losses being made on the trade.

- The calls rise 99%, to just below the level where they would’ve been sold, before falling again and not reaching that level again before expiration.

- The puts rise 99%, to just below the level where they would’ve been sold, before falling again and not reaching that level again before expiration.

- The stock goes through a period of consolidation with limited volatility, neither the calls or puts rise to the level of the sell orders and the value of both contracts depreciates as the time premium is eaten away.

- The calls/puts double and are sold successfully. However for whatever reason there is no bid on the losing contract and therefore they cannot be sold.

What do you think of this strategy in the current market?

ALL comments are appreciated!



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Reader Comments (10)

This is an interesting theory. I have been a futures trader for a while with some pretty good results. Lately I became interested in options because the downside is only limited to your initial investment. One way of doing a trade that might be interesting which I had some success with is this.

(I can't claim to be the inventor of this one) but you buy a LEAP call about a year or so out, in say, AEM near the strike price or just in the money, watch your entry points as you have been showing in your newsletter. Then sell or write a call at a further down strike price below the current leap, but at the nearest month to expiration. The nearest call will deteriorate faster than the leap and even though they may both move up, the Leap will move further because it doesn't deteriorate as fast.

The near month leap can either expire worthless meaning you pocket the value in full, or it can be bought back should AEM rise too high. In the event the stock falls unexpectedly, the near month leap will expire even faster for the same effect.

There are more specifics to this type of trade, but it can generate good returns every month. The outline of this plan can be found in a book called "The 36% Solution". I found it to be invaluable and an excellent read. Easily done in one afternoon.

Best of trading.

November 3, 2008 | Unregistered CommenterThe Maxman

It's a descent strategy. However, it is gambling. The market has already turned into a casino. I would prefer owning the stock out right or shorting the stock and buying a small amount of puts or calls depending, to hedge my stock, Calls and puts, could be good, or you could loose it all. It's a gamble. The other way at least you own the stock in hopefully a good company like AEM... protect your downside. If the stock falls, you make your money on the put and wait out the stock. Or by long term calls or just more stock, if your stock has gotten killed like Yamana. I wish I would have done that with my Yamana and Kinross. Didn't expect gold and silver to get killed like this.

November 3, 2008 | Unregistered CommenterGAry

If the options purchased are at the money in order for this trade to profit I believe it would be necessary for one of the two options to move into the money by an amount greater than the total price of the two options purchased.This amount can be enough to negate any profit,so my preference would be to pick a direction which I expect an option to move and place a market sell order on it to be executed should the underlying move in the wrong direction by a predetermined amount. By the way I pay approx seventy-five cents U.S per contract commission with my broker.

PS I appreciate and am learning from your letters.

November 3, 2008 | Unregistered CommenterGene Shannon

One other negative to this type of trade is that the premiums are higher when volatility is high. Therefore, you are paying more for an option during a volatile period such as now vs. another relatively calm time. Plus, bid/ask spreads tend to be wider during volatile times. Therefore, if I was doing this trade I would only trade the most liquid options I could find. Otherwise slippage will be quite substantial.

November 3, 2008 | Unregistered CommenterChiTrader

These strategies are very interesting. However, just like the market in general these days, full time attention is demanded for profit and/or to cut losses.

Just consider SKF for example and how much money could have been made over the last few months buying and shorting. All you need is a strong stomach and sitting by your computer all day watching the DOW.

Better yet, tell me what the market is going to do Weds.

John

November 3, 2008 | Unregistered CommenterJohn Ell

I think I would do more research on the subject before calling it gambling. I do however understand your point of view. Most option trades are considered gambling, but look at how gold-prices.biz has done with their recommendations. The same could be said for the strategy I listed.

I've attached the website for the strategy. (I am not a partner in any way with this site, just putting it up for further investigation.) My observations are that it is an active strategy and adjustments would need to be made in a volatile market, but the inventor of the strategy has close to 45+ years experience trading it and did so on the options exchange floor, so I wouldn't just throw it away as gambling. I would even say he makes a good case for why it is better than just holding a stock and selling an option against it. His gains are impressive, and verifiable.

Anyway, its worth a look. Then you can make your own decisions.

November 3, 2008 | Unregistered CommenterThe Maxman

For those that didn't get the website it is:

http://www.terrystips.com

November 3, 2008 | Unregistered CommenterThe Maxman

ive been following this newsletter for a couple years,just started buying the stocks this year that are covered in this newsletter..have been stating away from the canadian exchange only stocks cause here in the usa they are more expensive-floor fees,broker fees to buy and sell them---from experience ive seen a man of the name of WARREN BUFFET time the market time and time again do a better job than these guys in giving the time to buy,...these stocks covered on these gold uran silver sites have been good ones-especially the ones trading on the usa exchange also like agnico,yamana,hecla,etc,,.the ones on the major exchanges like the dow and nasdaq-i dont do canadian stocks that trade only on the canadian exchange-like silverado -what a disappointment! i look at the quality stocks-wait till after labor day usually late october cause october starts off usually bad then i wait till i see buffet announce its time to buy in my daily newspaper in the business section or wall st journal then i buy ! when buffet says buy it usually is a time when the WHOLE MARKET is near a bottom not just the stocks he follows---point in case--had you all waited for buffet to say buy instead of this site giving buy signals you ALL would have gotten MOSTLY ALL OF THESE STOCKS ON THESE SITES VERY LOW IN PRICE INDEED AND THEIR ALL MOVING UP NOW ! good luck to all-- the writers of these sites do a good job dont get me wrong BUT TIMING IS EVERYTHING! THATS WHY THEY CALL BUFFET THE ORACLE !

November 3, 2008 | Unregistered Commenterbill

The two things that drive the price of an option is the price of the underling security and volatility. Volatility also pushes bid ask spreads wider. My experience with straddles has been that the options more times than not are priced reasonably correct so that I seldom make that 100% and the options decay with time and all I get to do is salvage my loss. I also note that the combined +100% and -84% returns are too little return for the risk. A better strategy for me has been a vertical spread (buy the 50 call, sell the 55 call for a date) or a calendar spread (buy the longer option, sell the shorter option at the same price). If you bought AEM 50 calls and I wanted to follow, I bought the 50 calls and sold the 55 calls. Much better risk / reward.

I buy and sell the spread a set (not individual transactions), I get much better executions relative to bid - ask.

For calendar spreads, terrystips.com is a great resource. For options in general thinkorswim.com is an outstanding options broker and education provider. Get a play account at thinkorswim and begin to explore the tools at their web page and their educational resources. I had traded options for several years and have been with thinkorswim and Terrystips since February and I after 10 months I am still just scratching he surface of what I can learn there. I now have much better ways to analyze my proposed options trades. Thinkorswim also has a set of advisory services (Red Option) where you can follow their trades and explanations.

Full Disclosure - I don't work for or with anyone at thinkorswim or Terrystips, I don't hold stock in SWIM, I do not gain any benefit if you do business with either of them or not.

November 6, 2008 | Unregistered CommenterBC

Hey just wanted to "Like" this but I guess I'll just leave you a message. Great article.

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