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Approach Options Trading with 'Both Barrels Blazing'

Analyzing the straddle-buying strategy

by 9/30/2013 7:19:22 AM
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The following is a reprint of the market commentary from the October edition of The Option Advisor, published on Sept. 26. For more information or to subscribe to The Option Advisor, click here.

It is never an easy task to double your money on an options trade, but it is certainly possible and, in fact, options pricing models suggest that roughly one out of every five at-the-money options trades will expire at double the purchase price. But in exchange for this very nice capability on the profit side, we must also deal with the inconvenient truth that 50% of at-the-money options will expire worthless, and would thus create a total loss for the buyer.

But what if there was an options strategy that could generate gains (this year) such as 164% from buying iShares Silver Trust (SLV) options, or 103% from buying iShares 20+ Year Treasury Bond ETF (TLT) options, or even 250% from buying Broadcom (BRCM) options, with no real chance for a total loss?

Daily Chart of BRCM since September 2012
Chart courtesy of Thomson Reuters

And what if there was a service that provided recommendations based on this strategy that has produced portfolio returns of 82% year-to-date and 389% since the beginning of 2011? We've actually achieved these precise returns in our Schaeffer's Volatility Trader service, and this is part of why I've often referred to the options recommendations at the heart of Schaeffer's Volatility Trader as offering "The most attractive reward/risk equation ever for profitable options trading."

My enthusiasm for Schaeffer's Volatility Trader emanates from two major factors -- its core strategy (buying straddles) and our unique and highly effective approach for identifying stocks that are about to make much bigger moves than those assumed by the options models -- which is best expressed by my presentation above of some of the unusually profitable trades it regularly generates, as well as its very strong track record.

But let's take a look at the "playing field" for buying straddles, as I believe a better understanding of the benefits of "buying predicted equity volatility" ("buy straddle") as compared to "buying predicted stock direction" ("buy call" or "buy put") will greatly benefit you as an options trader or investor, whether or not you ever consider Schaeffer's Volatility Trader as a tool to potentially enhance your returns.

The "buy straddle" strategy underlying our Schaeffer's Volatility Trader recommendations involves simultaneously purchasing a call option and a put option with identical strike prices and identical expiration dates on the same security. Now, you might ask, if we know a stock is about to make a strong move in a particular direction over the option holding period, why would we "waste money" and purchase two option premiums, when our profit from buying the single premium corresponding to this "known direction" would be far greater? This is an excellent question, and it has a simple answer. No one "knows" direction -- we can only hope to be better at forecasting direction than the options pricing model believes we are (and, hopefully, a lot better than competing traders). So this "double premium" argument related to straddle buying is, to a large extent, based on a false premise. Plus, it is possible -- through careful research and study -- to develop a very effective set of indicators for predicting big stock movement that may be resolved in either direction, and buying straddles is tailor-made to profit from such forecasts for unusual volatility.

But there is yet another advantage to being a straddle buyer compared to a directional buyer -- by definition, one of the two option positions comprising your straddle (either your call or your put) will be in-the-money (and will thus retain intrinsic value) at expiration. And this means the chances for incurring a total loss from buying straddles are, in effect, zero. In sharp contrast, a trader buying an at-the-money call option to play a potential stock rally (and who thus "saved" the cost of buying the at-the-money put to create a straddle position) can expect this call position to expire out-of-the money 50% of the time. In other words, at-the-money call buying (or at-the-money put buying) can be expected to result in a total loss 50% of the time.

And there is even an additional advantage now being offered to encourage the straddle buyer -- as of right now, straddle buying is about as inexpensive as it has been in recent years. And with the cost for buying straddles now on the "bargain counter," this translates directly into higher profits for straddle buyers relative to the magnitude of the move achieved in the underlying stock. Why? Because the cost to purchase a straddle is extremely sensitive to the level of "implied volatility" (IV) prevailing in the options market. Using the PowerShares QQQ Trust (QQQ) as our proxy for the technology stocks we often find attractive in Schaeffer's Volatility Trader, current IV for QQQ options is about 13%. And over the past two years, IV for QQQ has been below 20% only about half the time, while reaching brief highs above 40% on several occasions. I believe the outlook for continuing modest levels of implied volatility (and for conditions favorable to straddle buying) is bright for the next 12-18 months, as the near-mania for buying volatility-based products (which tends to drive up IV) unwinds.

Do I love the straddles strategy as a lower-risk alternative to "pure" call buying or "pure" put buying, yet one that retains the potential to produce big profits on individual trades and outstanding bottom-line returns? Yes. But this is by no means an indication I have soured on directional call (or put) buying. Each approach -- buying options based on a view keyed to unusually large stock moves in any direction, and buying options based on a view of the direction a stock will move -- has its place in the arsenal of the option premium buyer. But if you'd like to begin approaching your options trading with "both barrels blazing," you might wish to contact us at 1-800-448-2080 or visit us by clicking this link for more information about Schaeffer's Volatility Trader.

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