Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. | 
Tom Gentile of Optionetics |
SIZING UP A STRADDLE BUY
I was looking at a particular stock for a possible straddle. The company is expected to release earnings in 10 days. Suppose I intend to purchase options that have 50 days left until expiration. According to my calculations, the straddle can be initiated for a debit of $400 ($2.00 for the put and $2.00 for the call), which is also my maximum risk. If I intend to hold this trade for only 10 days, would 5% of my account size be a prudent amount to risk? For example, if my account size is $10,000, I can only do one contract straddle if I was holding the trade close to expiry, but I can do more if I was only holding it for only 10 days. Am I right? The risk is less if my time frame is 10 days instead of 50?
Your question brings up some important factors that should be considered when evaluating a potential straddle: time decay, implied volatility, and maximum risk. The straddle, as you know, includes a put and a call on the same stock. Both puts and calls have the same strike price and the same expiration months. The idea is for the stock to make a big move higher or lower. If it rallies, the call can begin to yield profits if it increases enough in value (in this case, $4.00 or more). If the stock tanks, the puts increase in value and can provide the profits. A big move in the near future is the best-case scenario.
Choosing options with 50 days until expiration is reasonable. Thirty days or less and time decay becomes a bigger problem. Time decay refers to the fact that options are wasting assets and lose value over time. The impact is most significant as the options approach expiration. For example, an option with five days left until expiration will see a much faster rate of time decay when compared to a contract with 50 days of life left. For a straddle, time decay is twice as problematic because the trade involves the purchase of both puts and calls. There are two sets of options losing value. So if your plan is to buy a straddle with 50 days remaining until expiration, then close it in 10 days, that seems reasonable to me.
Another important consideration is the impact of implied volatility and how changes can influence the value of the straddle. Implied volatility is a component of an option price and tends to rise ahead of important events like earnings reports, Fda approvals, or new product announcements. The rise in implied volatility is the option market's way of telling investors to brace for a possible move in the stock price.
If you buy a straddle 10 days before an earnings announcement, implied volatility might already be high in anticipation of some post-earnings volatility. When this happens, it is known as a volatility rush, which causes an increase in options premiums. On the other hand, when the news has passed and the earnings are known, the premiums can fall due to a volatility crush. The volatility crush is a risk associated with buying options ahead of an earnings release. To find out if the implied volatility is high or low, some brokerage firms and trading software allow users to create volatility charts. I use Optionetics Platinum software. I never buy straddles when implied volatility is already high. Like with buying stocks, I find that it is better to buy low and sell high.
As for the percentage of your portfolio to risk, that is ultimately a personal decision and based on your own risk tolerance. Some traders use the 5% rule. Others are more conservative and won't risk more than 2% on any one trade. If you commit yourself to exiting the trade in 10 days, then the risk of your straddle is certainly not going to be $400. Both the puts and the calls will not lose 100% in value over the next 10 days.
So if your time frame is indeed 10 days and options expire in 50, you might increase the number of contracts to reflect the fact that you are not really putting $400 of capital at risk. However, this is extremely important; you have to exit the trade no matter what happens, even if the stock doesn't move and the trade is showing a loss. If you don't have the discipline to cut your losses and, instead, try to wait for the stock to move, then the risk is going to be more than 5% of your portfolio. In sum, the number of contracts for the straddle will depend on your risk tolerance and whether or not you really have the discipline to exit after 10 days -- even if the straddle is showing a loss.
A LESSON ABOUT LEAPS
What are LEAPS? How do you use them?
LEAPS stands for long-term equity anticipation securities, but don't be intimidated by the name. The contracts are no different than standard puts and calls, except they are longer term. They expire in two to three years. LEAPS are available on many of the more actively traded stocks, indexes, and exchange traded funds. For example, today, LEAPS with expirations in 2010 are available on Apple (AAPL), the PowerShares NASDAQ 100 Index Trust (QQQQ), and the Standard & Poor's 500 ($SPX).
LEAPS behave more like a stock than a short-term options contract. There is less of an impact from time decay and also less volatility. I use them in various trading strategies when I want to profit from the long-term rise in the equity market. For example, I sometimes create bull call spreads with LEAPS on stocks that may move higher over the next year or two.
Originally published in the March 2008 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2008, Technical Analysis, Inc.
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