Options strategy #1, the Long Straddle

The long straddle, I didn't know this was what it was called though.

For some time I have kept the idea of holding a long and short position simultaneously in order to hedge and take the eventual move, perhaps using some sort of calculated stop. Holding long and short positions in the same account is not allowed...but I have three accounts so I could do it. I eventually figured that there would be no real advantage and I would probably get whipsawed out of both positions for losses anyway.

Then I considered using ETFs. Always long positions but using bull and bear ETFs. I even tried this in a fake account by purchasing $100,000 of ETFs using a balancing method to ensure that the opposing trades were even based on dollar values. What I expected to see was a zero sum game. What I ended up with was an eroded account as the nature of the ETFs lost money in the end.

All in all I was better off just trading long or short and leaving the hedge alone...

...until now.

While playing with the options numbers I came up with a two trade strategy that should produce consistent returns. Like any strategy it relies on certain factors to work out in my favour, it's just that these variables seem easier to determine in advance of the trade and direction of the eventual move is not important.

Noting that the farther In The Money an option gets the closer the correlation of the option price move gets to the stock price move. The converse is also true, the farther Out of The Money it gets the less the correlation holds. Up is still up and down is still down but the ratio shifts to lessen the option price move compared to the stock price move OTM.

So, the strategy is this:

Buy At The Money calls and At The Money puts at the same time for the same stock with a long term expiry. When the price goes up the call option price goes up faster than the put option price goes down. The reverse also holds true. Both options benefit from an increase in volatility as well, but I am not sure how much of a factor this may be.

Stocks to use:

Stocks that are poised to move, say something that has a huge run up that may either continue or pullback. Perhaps something just prior to earnings announcements or big news events which may produce a large swing. There are tons of indicators that could be used to find these, and I tuned a scan to find two or three stocks that fit based solely on charts so the selection is small... intentionally so. No sense in having too many to choose from.

Things to watch for:

Buying the options right will help but may end up leaving me stuck with one side of the trade, the losing side, so limit orders may not be the best idea here. Market orders get me in but then the spread is already a loss.

Finding a stock with a large enough ATR (Average True Range) to ensure that the limits will both get hit or that the small loss is not a large factor would be good.

The last, and perhaps most important thing is to be reasonably certain that the stock is going to move within the timeframe of the option expiry. A stock that tends to languish for long periods of time is not one to choose.

I would consider that a setup that is likely to go in a particular direction already may be a good candidate as at least it will move, then concentrate on the position most likely to prosper first filling in the reverse position afterwards. Buy the call as the price is low and the put as the price is high is the best as this will take advantage of reducing the cost of the spread.

Advantages:

As long as the stock moves one option will out perform the other. I would consider this strategy an add on to existing trading. Something to play with and, if it proves consistently profitable, something to leave in the stable of trade strategies. Perhaps a nice slow account grower to use sideline cash in due to the lower risk associated with it.

An example I pulled from the first chart on my scan results:

CA...I didn't even check the company name, it doesn't matter anyway.

Using the February 22.50 calls and puts (the price is at $22.63 so it is close to the strike, another possibly good factor to consider)

Call option bid = $2.10, buy 5 contracts for $1050
Put option bid = $2.00, buy 5 contracts for $1000
Total capital = $2050

Assuming that the price rose $2.50 tomorrow to eliminate any time factors:
Call = 3.60, value = $1800 gain of $750
Put = 1.05, value = $525 loss of $475
Total value = $2325 for a net gain of $275... a 13.4% return on investment.

Obviously the gain by itself was a better profit as long as it was a correct call.

Assume the price dropped by the same $2.50.
Call = 1.05, value = $525 loss of $525
Put = 3.40, value = $1700 gain of $700
Total value = $2225 for a net gain of $175... a 8.5% return on investment.

Volume is a factor here as the more contracts purchased the greater the actual dollar amount gained. The downside may be the spread loss as it could be 10 to 15 cents per call which could suck $50 - $75 off of each side of the trade with 5 contracts. Spread is a large factor.

This will be tested next week...perhaps I can place a long straddle tomorrow to take advantage of some weekend volatility...we'll see tomorrow.

Jeff.