RUT straddle: How do you play this?

J

Joel Reymont

I'm experimenting with straddles on the ThinkorSwim simulator. Put on a straddle on RUT when it was around 780.65.

1 Feb 780 Call @ 14.40
1 Feb 780 Put @ 12.20

RUT is up 7.90 at 785.86, straddle is 16.85/9.65 or +245/-255 thus I'm still down $10.

How do you play this?!
 
MY first question to you is to esnure that you understand how straddles work, tell me the maximum risk and maximum reward for your position and tell me your breakeven points at FEB expiration.

Once you have done that, then you will get a better sense of why today's move is not significant for the straddle and why it is down.

Even better, on the ToS platofrm look at the $ value for theta and delta as well.

Once you answer those question we can move forward and highlight some key factors of straddles you should understand.

I am not trying to be an ass, I really want you to look up those answers yourself as part of the learning process and then you will get some useful commentary.
 
Hi Phil!

Thanks for taking an interest in my issue.

I'm planning to buy your book but at the moment I'm reading through McMillan and will read through Natenberg and Cottle, all of which I already bought.

My loss here is my initial investment, i.e. 12.20 + 14.40 + round-trip commission. Plus the spread of .40-.50 x 400 shares for the round-trip since I'm buying at the ask and selling to the bid. My profit is unlimited.

RUT is at 786.05 now. Delta is 22.64 and theta is -53.81. Gamma (just in case) is 2.36 and vega is 154.30.

I'm scratching my head over this as the risk analysis graph shows that I'll (likely) never make money on the downside since break-even is around 767. The break-even on the upside is somewhere between 786 and 787 but it keeps moving further out.

Thanks, Joel
 
ok now we are cooking. First, I would recommend you digest McMillian and Natenberg before considering my book or even Cottle's. Those two are more than enough reading for now lol.

OK lets attack the straddle.

1. You are correct that your maximum risk is $26.60 on your $780 straddle. (let's forget the realistic slippage and commissions since they are minor for now).

2. So that would put your breakeven points at $780 + $26.60 = $796.60 on the upside and $753.00 on the downside. Look at those breakeven points now and think whether RUT has any chance of being above 796 or below 753 by expiration. If you do not think so, then that is your first clue as to why the position is losing money or why it might not make any money by expiration.

3. ToS is probably showing the breakeven points as of today. Since there is still time to expiration, the options have time value premiums and the RUT does not have to move to 796 on the upside for the position to show a profit. That is why it is showing 786 or so as an upside breakeven point. However as each day passes to expiration the breakeven points will rever to the expiration breakeven point on the upside of 796. Thus it keeps moving wider out.

4. The reason I asked you to look at delta and theta is to see how time decay is a huge negative in straddles and it greater than delta (since straddles are initially delta neutral and stay that way unless the underlying really begins to move away from the strike.

5. Your position Delta is $23 and your theta is -$53 (rounded). What this means is that if in one day the RUT moves 1 point higher, for example, the straddle gains $23 in deltas but loses $53 in time decay for a negative net outcome. If this happens day after the day you can see how the position will shrink. The only way the position makes money based on the above is if the deltas get bigger than the time decay. In order for delta to get bigger, the RUT has to make a large move away from the strike price. Therefore, if the RUT hangs around $780 time decay is killing you. With a wide set of breakeven points I would say +/- 10 points higher or lower is not enough of a move to make money for you on this straddle with just a few weeks to expiration.

6. ToS allows you to change the date setting to look at today and then +1,2,3,4 o5 days with each step all the way to expiration. Do that and you will see the breakeven points move further and further out until they hit the expiration breakeven points I mentioned above.

7. Straddles are not just for any move in either direction, they are for significant moves, especially when on this one you have a $26 point premium.

I will stop there and we can take it from there after each point sinks in a bit.

Glad you are doing this on a simulator to really learn. (natenburg will help with the greeks).


Quote from Joel Reymont:

Hi Phil!

Thanks for taking an interest in my issue.

I'm planning to buy your book but at the moment I'm reading through McMillan and will read through Natenberg and Cottle, all of which I already bought.

My loss here is my initial investment, i.e. 12.20 + 14.40 + round-trip commission. Plus the spread of .40-.50 x 400 shares for the round-trip since I'm buying at the ask and selling to the bid. My profit is unlimited.

RUT is at 786.05 now. Delta is 22.64 and theta is -53.81. Gamma (just in case) is 2.36 and vega is 154.30.

I'm scratching my head over this as the risk analysis graph shows that I'll (likely) never make money on the downside since break-even is around 767. The break-even on the upside is somewhere between 786 and 787 but it keeps moving further out.

Thanks, Joel
More...
 
Quote from optioncoach:

ok now we are cooking. First, I would recommend you digest McMillian and Natenberg before considering my book or even Cottle's. Those two are more than enough reading for now lol.
More...

Will do! So much to learn :-).


5. Your position Delta is $23 and your theta is -$53 (rounded). What this means is that if in one day the RUT moves 1 point higher, for example, the straddle gains $23 in deltas but loses $53 in time decay for a negative net outcome.
More...

I wonder how long it would have taken me to figure this out on my own :-). It's been in front of my eyes all along but...


7. Straddles are not just for any move in either direction, they are for significant moves, especially when on this one you have a $26 point premium.
More...

I now understand the meaning of buying straddles cheap! The cheaper the straddle the less significant the move needs to be! /running for cover/


Glad you are doing this on a simulator to really learn. (natenburg will help with the greeks).
More...

Well, it's a must, I feel. I started by putting 3.5k into my account, buying Apple calls and running it up to 5.1k after MacWorld. I missed the move down to 85, though, so it was a dumb trade in retrospect.

I then proceeded to roll the whole 5.1k into more calls to play on earnings... which turned out to be even dumber as I proceeded to go from unrealized P/L of 6.2k to 0 :-(.

I scaled into 8 contracts at the end and these were deep ITM 90 calls with my maximum P/L above around 97.


I should have either done a straddle or bought a put for protection, obviously, but hindsight is always 20/20. This is the reason for my interest in straddles.

Overall, I learned a great albeit very expensive lesson.
 
To trade straddles you must understand volatility and how it works. Volatiltiy increases as uncertainy and fear increase and leading up to a news even when a stock is going to make a large move off of the news.

here is the most illuminating exercise you can ever do.

Go to www.ivolatility.com.

Enter GOOG in the spot near the top where it asks for a ticker.

Look at the historical IV chart on the right (click on it to make it bigger). Look at the IV of GOOG's current month options tracked over the past year.

Go back and find the dates for GOOG's past 4 earnings's announcement and match it up on the IV chart. Notice how IV spikes up right before the announcement, crashes after the announcement and is at its lowest usually in the 6 weeks after/before earnings.

Next look at GOOG right now since its earnings are a week or two away and track the IV leading up to this point. Also look at FEB options v. MAR and notice the different in IV.

This little lesson will teach you more about IV than a lot of option traders know and once you master the IV concepts, you can get a better understanding of when straddles work best and when they are not the best strategy.

There is more to it, but let's start there.
 
I must be lucky today. With RUT +10 at about 788.13 I sold the straddle for a profit of $45.

In: 14.40/12.20, net 26.60
Out: 18.75/8.35, net 27.50
---
+45

After the above explanation, I don't think I would do this again, though.
 
I do not think there was really anything wrong with the position, you just needed a sizable move to realize a profit. With indexes it is a little harder since the options are priced for large moves usually and the puts are skewed higher in price.

At least you got out with a profit and lesson lol.

Quote from Joel Reymont:

I must be lucky today. With RUT +10 at about 788.13 I sold the straddle for a profit of $45.

In: 14.40/12.20, net 26.60
Out: 18.75/8.35, net 27.50
---
+45

After the above explanation, I don't think I would do this again, though.
More...
 
Quote from optioncoach:

Next look at GOOG right now since its earnings are a week or two away and track the IV leading up to this point. Also look at FEB options v. MAR and notice the different in IV.
More...

For calls:

26.33 -> 34.92 -> 38.76
month ago -> week ago -> current

Puts about the same.

Interestingly, Feb 480 calls are 39.73 vs 35.11, Feb vs. March. 490s are 39.40 vs 34.70.

I guess this reaffirms that volatility drops after earnings and it's best to buy when IV is low, right?

Why the IV difference between March 480 and 490?


There is more to it, but let's start there.
More...

I'm eager to proceed, as always! Thanks Phil!

IV also applies to a question I asked earlier at http://www.elitetrader.com/vb/showthread.php?s=&threadid=85129.

The WSJ article didn't say what strikes were being bought but I guess tradersa are looking to profit from the dollar movement while minimizing the cost of their straddles due to lower IV. Am I right?

I wold also guess that time decay does not matter to them as they would be selling right after earnings, i.e. not holding to expiration.
 
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