Explore Your Options

with Tom Gentile

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.

I like the idea of positioning with long straddles, but when it comes to pulling the trigger, I’m having problems executing. More often than not, the spreads that look the most attractive overwhelm me with the actual cost to initiate the strategy and/or the associated time decay. Can you offer any insight that might help me get over this barrier to entry?

That’s a very good question to a situation many investors battle with in developing a trading plan. Your central dilemma seems to involve time and its impact on both shorter- and longer-term straddle pricing. This impact boils down to heightened concerns regarding increased decay risk when dealing with a near-term straddle versus a larger capital outlay and larger dollar exposure of the longer-term straddle if left unmanaged during the life of the contract.

For instance, if it’s January and shares of Abc are at $35, the April 35 straddle might trade for about $3.50, while the February 35 straddle with one month until expiration is priced at $2.00. Over the next month, if shares sit or go nowhere, theta will eat up the entire value of the February straddle or $200 per spread.

At the same time, because theta is not linear but works as a function of the square root of time, if volatility remains flat, we could expect the higher-priced April straddle to lose a lesser $0.65 per spread or so and trade for $2.85 in the open market a month later.

By looking at this issue of cost versus decay, having a firm idea of time frame expectations based on your analysis and considering what type of risk management rules you have in mind prior to entering into any type of position, you should be better equipped toward finding and executing straddles more confidently and consistently.

Another strategy that may have been overlooked but might help on occasion would be the long strangle. The at-the-money strangle will cost less than the same-month straddle, but the reduced price tag does come with the less-desirable characteristic of wider breakeven points, which should be considered.

Finally, we know that by establishing a straddle, the trader is looking for a big move and/or increase in implied volatility. But do you have a bias with regard to which way shares might move if push comes to shove? If you maintain some kind of bias beyond simply expecting a strong move, a ratio backspread could be an option to think about (if you’ll pardon the saying).

A typical backspread is the 1x2, wherein one contract is sold and two are purchased. If the trader sees a move in shares as forthcoming but estimates upside as being more likely, he or she can sell a lower strike call and buy more contracts of a higher strike call in the same month. For expectations favoring a downside move, the trader could use all puts and purchase the lower strike.

When the backspread is executed for a credit, an explosive move in either direction will land a profit, much like with the long straddle. If shares sit at the purchased strike, the ratio backspread will result in a smaller loss than the equivalent long straddle placed on the same strike.

The drawback or sacrifice to this strategy is when shares move explosively in the direction opposite our expectations. Compared with the “near” open-ended profit potential of the long straddle, the trader is only collecting the initial credit of the backspread. Despite the win, there could be a substantial profit difference involved relative to the long straddle. The adage “you get what you pay for” does come to mind, and the trader needs to consider it when weighing the two position types.

On more than a few occasions, I’ve noticed call prices relative to their put equivalents trading at a discount. I know this type of situation is often tied to shares being hard to borrow (Htb) or potentially difficult to short. If I’m bullish and simply want to buy a call, isn’t this an opportunity to buy the option cheaper than otherwise would be the case?

This is the type of situation where I would say the cheap call comes with a likely cost down the road. The call buyer is initially given a theoretical edge with the purchase. Important to consider, however, the straight-up call buyer loses any theoretical advantage immediately when any potential hedges are passed on at the time of execution.

Further, while the initial objective is to make a directional play, any eventual hedging that is considered in an effort to reduce the bullish deltas should be expected to come with an offsetting disadvantage. The problem is the implied skew that made the call theoretically attractive could still exist, as Htb situations don’t just simply get resolved overnight.

That said, when the trader is finally considering an adjustment, selling a call either to close or another short call to open as part of a spread could be expected to be cheap. As part of the pricing dilemma, purchasing a put to hedge would be expensive due to the elevated skew attributed to the Htb situation.

The only scenario where the call buyer truly comes out ahead both entering and exiting is if shares move up enough and the call becomes so deep in-the-money that it loses all of its extrinsic or time value. In such a situation, the trader could exercise the long call without forfeiting premium and sell stock simultaneously to flatten out the position into cash. However, this trader needs to realize what they’ve done is execute a profitable directional bet that ultimately has little to do with buying a theoretically cheap call.

Contributing analysis by senior Optionetics strategist Chris Tyler.

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