An Insider's Take On Trading Straddles

Founder and CEO Bernie Schaeffer interviewed Schaeffer's Senior Trading Analyst Bryan Sapp on the options straddle strategy

by Bernie Schaeffer

    Published on Jul 5, 2016 at 4:12 PM
    Updated on Jul 5, 2016 at 4:14 PM

    The following is an updated interview that originally appeared in the Fall 2012 issue of SENTIMENT magazine, and was reprinted in the market commentary from the July 2016 edition of The Option Advisor, published on June 23. For more information or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- click here.

    I recently sat down with Senior Trading Analyst Bryan Sapp to discuss the excellent performance of Schaeffer's Volatility Trader, a subscription service we offer at Schaeffer's Research, whose focus is on buying straddles (see "Straddles 101," right). Sapp develops the trading recommendations for Volatility Trader, which as we go to print has generated a remarkable portfolio return of 508% since inception (July 2010). After reviewing my notes, I realized there can be no better way to explain our successful approach to profiting from big moves in equities, regardless of direction, than to create a transcript of our discussion and present it to you. So please read on, as you may as a result achieve a significant breakthrough in the consistency of your option trading profits.

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    (Bernie G. Schaeffer) Buying a call and a put with identical strikes and expiration dates on the same underlying stock is derided by some as "copping out on picking stock direction" and "paying double premium for no good reason." How would you address these criticisms of the straddle strategy in terms of how we at Schaeffer's approach trading this strategy?

    (Bryan) I've typically had the best success with straddle trades in which I'm completely uncertain as to the ultimate direction of the underlying over the option holding period (whose maximum is defined by the amount of time remaining until option expiration). In other words, these straddle situations would simply not be traded if I had to pick a direction and buy a straight call or a straight put.

    I'm looking for situations in which the underlying is about to make an explosive move. This is often right after a relatively quiet period, which helps keep my costs down because the implied volatility (IV) component of the option price will tend to drift lower over such periods. These straddle set-ups would typically be considered unattractive for a directional trade.

    With straddle buying in your arsenal, you can view the indicator landscape -- historical and implied volatility, short-interest levels and trends, "coil" patterns on charts, earnings (and other macro catalysts) and option activity -- from the perspective of the probability of the underlying making an unusually strong directional move within the defined time frame. Straddle buying is not about being relatively uncertain on whether to be bullish or bearish on the underlying over the holding period and thus paying "double premium" to hedge your bets. Rather, successful straddle buying is about developing an indicator set that allows you to be relatively certain about the probability of stronger-than-expected directional movement by the underlying over the holding period, and then using straddles to leverage your profits from this scenario.

    Note also I am not forecasting higher volatility over the holding period, but rather I am forecasting unusually strong directional movement (which may or may not be accompanied by higher volatility). This may seem like a trivial distinction at first blush, but when you do some serious thinking about it, you realize it is the key to successful straddle buying. As you have said many times about buying option premium, you pay for volatility when you enter your option position, but the "currency" for your payoff for an options trade is the extent of the directional movement (and not the volatility) over the holding period.

    (BGS) Based on a standard "off the shelf" analysis of the probability of profit parameters for an at-the-money straddle purchase compared to the parameters for an at-the-money call purchase (or put purchase), it is clear that by buying a straddle you sharply reduce your probability of incurring a total loss (to the point where it is negligible) and you also increase your chances for achieving a profitable trade. How do these sharply different profit and loss parameters (along with the higher total straddle premium) affect the attractiveness of the straddle strategy and how you select and then manage straddle positions?

    (Bryan) Comparing the parameters of at-the-money call (or put) buying to those for buying at-the-money straddles leads to some very interesting contrasts on the following fronts:

    1. Probability of profit -- The probability that the buyer of an at-the-money call (or an at-the-money put) will be at break-even level or better if the position is held until expiration is about 35%. For the buyer of an at-the-money straddle, this probability of profit at expiration is about 42.5%. So despite the so-called "double premium" expense of buying a straddle, your chances of breaking even are significantly increased relative to the straight purchase of a call or a put. These probabilities are best understood in the following framework. A straight call or put buy must have a profit probability of less than 50%, due to the simple fact that you are paying a time premium for the privilege of owning the price appreciation of the security (in the case of the call purchase) above the strike price until the option expires. A straddle buy will have a higher probability of profit than a straight call or put purchase due primarily to the fact that you can profit from a robust move by the underlying in either direction. But your profit probability still must be less than 50%, again because of the time premium you are paying.

    2. Probability of a total loss -- In the case of a straight at-the-money call or put buy, the probability you incur a total loss is pretty straightforward at 50%, as you are basically betting the stock (which is trading at the strike price) will be above (in the case of a call buy) or below (in the case of a put buy) the strike by expiration -- which is a coin toss -- and if you are wrong you incur a total loss. In the case of an at-the-money straddle, the probability of a total loss is negligible, as it requires a precise close at the strike on expiration day for it to occur.

    3. Probability of a large profit -- In the case of a straight at-the-money call or put buy, the probability of at least doubling your money by expiration is about 21%, while the probability of doubling your money on an at-the-money straddle is about 11%. So, in theory, the "double premium" factor in straddle buying does directly and negatively impact your chances of achieving large profits.

    So, in essence, buying at-the-money straddles provides us with an increased chance of achieving profitable trades with an almost negligible chance of incurring total losses, but in exchange our probability of achieving big profits is reduced relative to buying at-the-money calls or puts.

    While the comparison of these parameters is certainly interesting and should be on the radar of all options traders, I'd suggest that the real benchmarks for the attractiveness of straddle buying relate more to your ability to find attractive straddle set-ups and manage your positions in such a way as to optimize your returns. As I indicated earlier, I don't buy straddles as a substitute for buying calls or puts. I look for completely different trade set-ups for my straddle trading.

    (BGS) We've already discussed the negative impact the "double premium" aspect of buying straddles has on the theoretical probability of achieving triple-digit profits (+100% or more) on successful straddle trades. How do you address this theoretical impediment in your straddle trading?

    (Bryan) I don't feel I'm operating at a disadvantage on the triple-digit-profit front as compared to those who trade directionally. I've had success with aligning the time frame of the straddle with the VIX environment (as a proxy for overall volatility levels). So, if we're running at a 40 VIX, for example, I'd tend to trade shorter-term straddles and vice-versa if the VIX is on the low side. The premise behind this approach is that volatility is mean-reverting, so you obviously don't want to lock in multiple months of time premium at a high IV. In my opinion, the key to achieving big straddle winners is the timing and location of your entry. This is where my work with Bollinger Band width really helps -- I like to see Bollinger Bands at or near annual lows, or turning higher from annual/multi-year lows.

    (BGS) The "low" dollar premium for weekly options would seem to create great temptation for the straddle buyer. What are the benefits and pitfalls of buying straddles on the weeklies? How should a straddle trader manage a weekly position to maximize his or her chances for success?

    (Bryan) The weeklies can be great straddle vehicles in a high-VIX environment. The tradeoff is they're very volatile and you run a much higher risk of larger losses due to the "pinning" of stock prices at or close to strike levels at weekly expiration. The major benefit of trading straddles using weekly options is the potential to generate huge winning trades due to their significantly lower dollar cost. The biggest winner we've had so far in Schaeffer's Volatility Trader was a straddle in the weekly options that was closed for a 240% gain. Simply stated, the higher risk of the weeklies can be accompanied by much higher reward. For position management of such straddles, I think the "half-life" rule is a good guide. If you have not achieved the desired move in the first few days after you enter the position (which will often occur at the point at which the weekly option has about half its original time remaining until expiration), then it's generally a good idea to close your position and move on to the next trade.

    (BGS) Does a lower IV environment present additional profit opportunity for the straddle buyer? Are there pitfalls for the straddle buyer in such an environment?

    (Bryan) Low IV can be good, but I actually prefer a higher volatility environment. The long-term chop and tight Bollinger Bands of late signal that the market is setting up for a big move, and straddles could be a way to trade the uncertainty.

    The biggest benefit of low vol environments is the potential for a stock to steadily trend with the market. If this happens, you don't get "chopped up" and will at least show some profit. However, the big straddle winners typically come at times when we see 2%-plus intraday moves on the indices. The ability to time inflection points on single stocks is aided by big market moves. Once again, it comes back to the risk/reward principle. I typically have a higher win rate in lower vol environments, but the 150%-plus winners aren't there as often as they would be when we have big swings overall.

    (BGS) No trade setup is ever ideal, and sometimes those that look "too good" can involve more danger than opportunity. But with these caveats, how would you describe an ideal setup for a straddle trade?

    (Bryan) The symmetrical triangle, or "coil" pattern on the charts, is still my favorite setup for consistency for straddle trades. The longer the "coiling period," typically the bigger the move will be if and when the triangle breaks. Coupled with this chart pattern, I like to see increasing levels of short interest (either a big recent spike, or short interest at multi-year highs), and low-to-modest implied volatility. These parameters have defined the core of the trades for Schaeffer's Volatility Trader, and we have achieved more than our share of big winners. I'm always on the lookout for symmetrical triangle patterns, but I also need to see short interest and IVs positioned the way that I like.

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