Nov

2

Assessing the Long Straddle Profit & Loss

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Long Straddle Profit & Loss
 
Ron Ianieri, co-founder of the Options University and author of their renown Mastery Options course, provided an excellent example of how a Straddle functions. For example, we buy the May $55 straddle and let’s say the call is trading at $3 and put is trading at $2.80. The straddle is actually going to equal a total of $5.80. What does that mean?
 
The point of maximum loss is the $55 strike itself. The worst place for the stock to wind up when you’re long a straddle is directly at the strike at expiration. When it’s directly at the strike, our call is going to go out worthless so we’ll lose the $3 there, and we will also lose the whole $2.80 we paid for the put. So, the worst place for the stock to close when you’re long the straddle is directly at the strike.
 
To find the up-side break even, we simply take the strike price of $55 and add it to the total straddle price. In the example, that’s going to give us $60.80. That is going to be our up-side break even.  
 
To calculate our-down side break even, we take the strike price and subtract the total straddle price. In out example, $55 minus the total straddle price of $5.80 gives us a down-side break even of $49.20. That means by expiration the stock needs to be either below $49.20 or above $60.80 for you to profit because come expiration the long straddle holder or buyer only profits in the area above the up side break even or below the down side break even.
 
In the case of our $55 straddle, the stock has to go up $5.80 just to break even because that’s how much we paid for the straddle. That means that the stock has to go all the way up to $60.80 just to breakeven. At $60.80 the put will be worthless but at $60.80 the $55 call will be worth $5.80. The value of the spread will be $5.80, $5.80 in the call, zero in the put; and the position is at breakeven.
 
If the stock traded down to $49.20 the call will be worthless so we lose the whole $3 premium for the call but with the stock trading at $49.20 the $5 put will be worth $5.80. As we paid $5.80 to get in the position, it’s now worth $5.80 because there’s $5.80 in the put and zero in the call, we have broken even.
 
In summary, a straddle needs large movements to be able to move past the wide breakevens caused by the high premiums. Not only are at-the-money premiums at their highest, but usually the market is aware of the potential price move and has priced it into the premiums. As a result, straddles are usually applied in very special situations where large price swings are possible.
 
For all things stock option, contact Options University at www.optionsuniversity.com

Nov

1

Option-pricing models – Using Volatility

Filed Under Beginner Options Trading | Leave a Comment

When we value a football bet, there is no way to say for certain it is properly valued. It’s a question of the perceptions of the bettors. The casinos simply find out how many people wish to bet on each team and then create the necessary point-spread to balance the number of buyers.
 
Prior to 1973, this is exactly how the options market worked. Traders had to throw out bids and offers based on what they felt the trade was worth. Of course, this type of valuation means that traders tend to bid low and offer high, which creates very large bid-ask spreads. This makes the market very inefficient and never quite gets off the ground. Fortunately, that all changed in 1973 when Fisher Black and Myron Scholes created the Black-Scholes Option Pricing Model, which allows us to get a more scientific idea of what an option “bet” should be worth. It’s no surprise that this was the very year the Chicago Board Options Exchange (CBOE) was created since there was now an objective way to readily determine the fair price of a “bet” with an option.
 
As you get more advanced with your option trading, it is imperative that you use some type of option-pricing model. Option-pricing models allow traders to judge whether the price of an option reflects a good value. As we will show later, had we used the Black-Scholes Model, there would have been a big red flag flying above the $4.80 price of the $20 call option.
 
Let’s see how the Black-Scholes Model could have prevented us from taking this loss. We’ll rewind back to the beginning when we were looking at the AGIX $20 call for $4.80. Before we make this trade, we need to get a benchmark for value very much like we did for the eBay Iraqi currency. As traders or investors, we cannot just pay the asking price as if it’s the price of a lottery ticket. Lottery tickets have no point-spread to them. You either win or you lose (mostly lose). You cannot be correct on the numbers for a lottery game and still lose the bet. With options though, it’s different because the price we pay has a point- spread built into it and we need to understand what that spread is. In order to value this $20 call, we need to estimate the future volatility of the stock.
 
 
Volatility Moves Sideways
Before we show you how to estimate the future volatility, we need to take a short detour here and explain a very important characteristic about volatility. That is, volatility tends to move sideways over time. For example, Figure 6-10 shows an 18-year history of the Volatility Index, or VIX, which measures the volatility of the S&P 500 Index. Although the index has risen substantially over this time period, notice that the volatility chart just moves sideways.
 
Figure 6-10: Volatility Index (VIX)

Option pricing models Using Volatility

 
 
This sideways characteristic of volatility is about the only constant in options trading and that’s why it’s so important to understand. When volatility rises, there’s a tendency for it to fall and vice versa. This shows that there is some long-term average that the volatility oscillates around. The tendency for volatility to fall toward the long-term average is called mean reversion. That is, volatility tends to revert to the mean (average). Mean reversion is nothing new and occurs in many types of events, not just options trading. In order to understand the mechanics of mean reversion let’s take a look at a well-known and rather intriguing mystery known as the Sports Illustrated Jinx.
 
The Sports Illustrated Jinx is a marvel well-known to professional athletes. The jinx states that if a professional athlete makes the cover of Sports Illustrated, they have just been jinxed and their performance is headed for a slump. There has been a very long (and quite convincing) history of this ever since Sports Illustrated was first published. The jinx became so commonly believed that in January 2002, Sports Illustrated wanted to publish a feature story about the jinx and asked St. Louis Rams quarterback Kurt Warner to pose on the front cover holding a black cat. But Warner refused so they shot the cover with the black cat by itself with the intriguing caption: “The Cover that No One Would Pose for. Is the SI Jinx for Real?” 
 
Figure 6-11
 Option pricing models Using Volatility
 
It certainly sounds like it’s no tribute to be an athlete featured on the cover of Sports Illustrated. But let’s look at this phenomenon in another light. Figure 6-12 shows baseball superstar Mark McGwire made the October 1998 cover by hitting his 70th homerun of the season:
 
 
Figure 6-12
 Option pricing models Using Volatility
 
This was a feat that had never been done before in history. It was so remarkable, in fact, that it landed him on the cover of Sports Illustrated. So how many homeruns should we expect from him next season, 71? And then 72 the following season? Of course not. This was an all-time record high – that’s why he made the cover of the magazine (you don’t make the cover of Sports Illustrated by having an average season). After some thought you’ll realize that we should not expect him to outperform that record next season but, instead, fall back toward his long-run average. And he did, in fact, hit 65, 32, and 29 homeruns in the following three years – right in line with his long-term average of 35 homeruns per season.
 
Mathematician and author John Allen Paulos came up with a brilliant way to show that the Sports Illustrated Jinx is nothing but mean reversion at work and not an apparent slump as it appears. He suggests that the magazine choose the player with the worst record of the season and place his picture…on the back cover. Paulos is quite certain that you will see an increase in the player’s performance the following season. So whether you’re the best player on the front cover or the worst player on the back, we should expect both players’ averages to move toward the center. The bottom line is this: Any time an extreme event happens, whether good or bad, chances are that following events will be less extreme, not more.
 
Figure 6-10 shows that the VIX tends to bounce back and forth between 20% and 40% most of the time. When it moves significantly outside of this range, we should expect it to revert back to the average rather than to continue to rise or fall. That’s why the overall volatility trend moves sideways. We should not expect to see volatility rise month after month any more than we should expect Mark McGwire to continually outperform his record each season. Instead, we should expect extreme events to be followed by less extreme events.
 
Using Volatility
Now that you understand volatility, let’s see if there is a way we can use this sideways characteristic to gauge the value of an option. Let’s go back to the AGIX trade we discussed at the beginning of the chapter. Figure 6-6 showed us that the $20 call was priced at $4.80. But we also said that there can be significant differences between an option’s price and its value. How do we check the value? We must compare the current price with past volatilities. Before we buy this (or any) option, we need to check the past volatility of the underlying stock.
 
Most option brokers supply this information if you have an account with them. However, if they do not, you can find some basic information free of charge at www.ivolatility.com. Figure 6-13 shows what you will see on the front page:
 
Figure 6-13
 

Option pricing models Using Volatility

 
If you type the option symbol in the box shown by the upper circle and then click on the chart in the lower circle, it will take you to the moving average of the volatility of that stock. As a general rule, you’ll want to match (at least closely) the volatility moving average to the expiration of the option. In this example, the AGIX $20 call had 29 days until expiration so we’d want to use a 30-day moving average, which is one of the standard time frames available from this website. Figure 6-14 shows the 30-day volatility moving average for AGIX over the previous year (9/16/2004 to 9/16/2004):
 
Figure 6-14: 30-Day Volatility for AGIX
 

Option pricing models Using Volatility

 
It’s important to understand how to interpret this chart. Remember, this is not a price chart on AGIX; it’s a chart of the volatility. To create this chart, the computer takes the first 30 days, calculates the volatility number, and then plots that number as a single point on the chart. Next, it takes days 2 through 31, finds the volatility number, and then plots that number as a single point on the chart. This process continues for all 30-day groups in the data. When it’s done, all the dots are connected and you’re left with a fluctuating line as shown in Figure 6-14.
 
You can see the highest 30-day group had a volatility of about 70% and the lowest around 35%. The current level is about 55%. The million-dollar question now is which volatility should we expect over the next 30 days? In other words, which volatility should we use to determine the value of the AGIX $20 call?
 
 

To be continued…..

Nov

1

Advanced Options Trading – Straddles

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Straddles
 
A long straddle is a strategy which is set up to give you a non specific directional trade. What does that mean? If we don’t have a clear idea of which direction the stock may be moving, we would want to be in a position to make money if the stock moves in either direction. One important characteristic of the scenario is that this strategy is used when the stock is highly volatile and has a potential large price movement-in either direction. It will either go up big or down big but you aren’t sure which way it’s going to go. But you know that its going to move.
 
Most typically, straddles are most often used when some significant news related event could have a large impact on the stock. We have some sort of idea when the news release is coming out but we’re not sure what the news is but it’s the type of news that can move the stock.
 
For example, we know roughly when earnings are going to come out. We’ve have an idea that if earnings are better than expected the news will move the stock up. If the reports are worse than expected, the news will probably push the stock down. Along the same lines, Information about a new drug, passing FDA clinical trials, court hearings or a major court situation can also move the stock and usually the least expected announcement will have the greatest impact. We might hear that some news is coming out on a stock but not know exactly what it is. Because we don’t know which way the news is going to affect the stock, we can hedge out bets by putting on a straddle.
 
If we are not sure which way the stock will move, we just buy a call and a put in the same month and strike price. This is called a long straddle. In theory, it’s a thing of beauty. If the stock goes up, then our call kicks in and eventually our put dies out and the call gains money with the rise of the stock. If the stock moves to the down side, our put kicks in and the call eventually goes to worthless as the put is gaining unlimitedly as the stock moves down. However, if the stock doesn’t move either way, we languish and suffer the maximum risk of cost of the call and put premiums at expiration.
 
However, the market may very well be aware of the same information you have and the volatility will push up the price of the premiums. If the market has already priced in the anticipated news, the stock may not move enough to cover the high premiums.
 
The short straddle is a premium collection strategy. The one thing we’ve got to realize about a short straddle is it’s not fully hedged. At Options University, they preach against holding an unhedged short option but there’s a little bit of a difference with a straddle.
 
With the short straddle, we’re selling a call and selling a put. Only one of them can hurt us and that is the one that moves into the money and can be exercised. However, because we collect substantial premiums for selling these options, the premium collection will give us a nice wide break-even.
 
The short straddle is the most powerful of premium collection strategies but it’s also the riskiest because we are short two options and if the stocks moves in either direction we are going to be short a naked option with a good sized loss.
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