*This article was originally published in The Option Strategist Newsletter Volume 7, No. 9 on May 14, 1998. *

One of the main strategies that this newsletter has employed over the past couple of years has been straddle buying. Yet, in looking back over the articles that have been written, there has never been one that specifically discusses this strategy. So, this issue will remedy that omission, while shedding some light on how profitable one can expect this strategy to be.

Let’s start at the beginning: the purchase of a straddle is the purchase of a put and a call with the same terms (i.e., same expiration date and striking price). Once one owns a straddle, he can make money if the underlying instrument moves far enough up or down. “Far enough” means that the underlying rises to a distance above the strike price equal to or greater than the combined cost of the put and the call (i.e., the cost of the straddle), or – alternatively – that it falls below the strike by a similar distance. An example will help explain this simple strategy:

Example: with Gateway (GTW) trading near 40, the June 40 call is bought for 5 points, and the June 40 put is bought for 4 – thus the entire straddle costs 9 points. If GTW subsequently rises above 49 (the strike price plus the straddle cost), the call must – by definition – be worth at least 9, since it is 9 points in the money. Thus, the straddle buyer would have a profit. Alternatively, if GTW were to fall to 31 or lower, the put would be worth at least 9, for it would then be at least 9 points in-the-money.

Novice investors often find that straddle buys look especially attractive. For example, if one picks up a chart of Gateway, he might see that GTW seems to have 9-point moves rather often. Based on this simple analysis, one might figure that the straddles are an attractive buy. However, there is a flaw in that elementary evaluation.

Consider that this movement might occur: first, GTW rises 7 points in price – to 47 – and then drops 14 points to 33 (and maybe even then rises 10 points to 43). If this happened while you owned the straddle, there is a distinct possibility that you would not have made any money because GTW never got above 49 or below 31 – the breakeven points. So, even though the chart would show the 14- and 10-point moves, in retrospect, they did not come from levels that produced profitability for the straddle owner.

Hence, more rigorous analysis is needed. Although no form of analysis will guarantee a profit, we have found that the following steps tend to ensure a position where the odds are in your favor:

- only buy cheap options
- verify, statistically, that the underlying has a good chance of moving the required distance
- observe the past movements of the underlying
- factor in any fundamental news

We'll discuss these in more detail:

1) only buy cheap options. We look for straddle buys when the options’ implied volatility is in the 10th percentile or lower. That is, the options are currently priced so low that over 90% of all past implied volatility readings are higher than the current one. Typically, we try to look back at least three years to make this comparison. The table of “Implied Volatility Extremes” (page 8 this week) that we normally publish in The Option Strategist is a good starting place for this analysis. The advantage of enforcing this criterion is that – if the options return to a more “normal” implied volatility, the straddle owner will benefit.

2) verify statistical movement. Using historical volatility, analyze whether the underlying instrument can actually move the required distance to the breakeven points of the straddle you are considering buying. This analysis is performed with our probability calculator, which – given historical volatility as an input – estimates the probability of the underlying ever hitting one or the other of the breakeven points prior to expiration of the straddle. This criterion is necessary because we want to ensure, based on actual statistical (historic) volatility, that the stock has a good chance of being able to move far enough to make the straddle purchase profitable.

3) observe past movements. Even if the straddle purchase looks attractive under the first two forms of analysis, I still like to look at a chart to see whether the stock has actually made moves of the size required – in the time required – to warrant a straddle purchase. This criterion is essentially the same as the “simple” one that was mentioned earlier. However, ideally we would like to see if the underlying has had moves that are twice the straddle price. If it can move that far, then it would certainly have to produce a profitable straddle purchase.

4) factor in fundamental news. For example, if the underlying stock has received and accepted a takeover bid, it will be stagnant at the takeover price and its options will be very cheap. Obviously, such a stock has little chance of movement, so the fundamentals overrule the statistics and the straddle would not be bought.

None of these criteria is sufficient by itself. All are necessary. For example, just because the options are cheap with respect to where they have been trading over the past three years, that does not actually mean that the straddle is an “automatic” buy. Similarly, even if the underlying has a good statistical chance of moving the required distance, it is not good policy to buy inflated straddles because the passage of time and/or a reduction in implied volatility will weigh heavily against the owner of the straddle. And – as we saw earlier – just looking at a chart for past movements, while ignoring the “math” of the situation, is a poor analytical method.

Continuing on with our Gateway example, let’s see how these forms of analysis were actually used when we recommended the Gateway June 40 straddle purchase in Position E94. The following chart will be used to describe the analyses:

The graph shows the stock price chart on the top half and the daily implied volatility readings on the bottom half. The rightmost data bar in the chart is Feb 6, 1998, the day we recommended the June 40 straddle purchase via the HOTLINE. The scale on the right side shows the stock price for the top chart and the actual daily implied volatility readings (not percentiles) for the bottom chart. 1) only buy cheap options. By looking at the bottom line on the chart, you can see that the implied volatility of options on GTW was at its lowest point on Feb 6th. The options had been cheap for several days, but that was the cheapest day to date. Thus, the options were in the 0th percentile at the time – i.e., they had never been cheaper. In fact, for some reason, the options’ implied volatility had been plunging for about 10 days. When these situations are observed, I am often asked “why are the options so cheap?” or “why would traders allow the options to get so cheap?” Frankly, I have never found a good answer to that question (unless the actual fundamentals of the company are changing), but as a technical analyst, it is not necessary to answer such questions – we’ll just go with the “math”. When buying straddles, always allow at least 3 months in time. Thus, we wanted to consider the June 40 straddle, which was selling at about 9 points at the time. 2) verify statistical movement. On Feb 6th, 1998, the following historical volatility statistics were available:

10-day actual volatility: 32% 20-day actual volatility: 43% 50-day actual volatility: 54% 100-day actual volatility: 61%

As these things go, those are very disparate actual volatilities. One would expect to see some differences, but these seem extreme. So, which one should we use in performing a statistical analysis? I generally favor using the average of the 10-, 20-, or 50-day. In this case, we’d use 43%. Now, based on actual past statistical movements of Gateway, it seems like we’re using too low of an estimate. But at least this way, we’ll be getting a conservative estimate from our probability calculator. So these are the inputs that were given to the calculator:

Stock Price: 39-3/4 Upside breakeven price: 49 Downside breakeven price: 31 Trading days remaining: 92 Actual volatility expected: 43%

The probability calculator estimated that there was an 84% chance that either 49 or 31 would be hit at some time prior to June expiration. If the probability is greater than 80%, I consider it significant. 3) observe past movements. We want GTW to be able to move either 9 points higher or lower within about 4-1/2 months (from Feb 6th to June expiration). The following graph shows the price chart of GTW, with a “box” superimposed on it. That box is 18 trading points high and 4-1/2 months wide, per the scale on the chart. That box is the “containment box”; if GTW can’t get out of that box – or hasn’t been able to get out of it in the past – then we may not have a good straddle buying situation.

The “box” is placed on the graph about a year ago. You can see that if you paid 9 points for a straddle at that time, you would not have made a profit. The stock fell to about 24, then rallied to about 37, but never broke out of the box. On the other hand, if you visualize moving the box forward in time, the box has not be able to contain GTW since then. So, while this isn’t “perfect”, it seems reasonable that GTW can move far enough. By the way, if you use this “box” technique, where the height of the box is twice the price of the straddle, it is a very onerous constriction on any straddle purchase. But, as explained earlier, if we make the box’s height only equal to the price of the straddle itself, that is too lenient of a requirement – for the stock could move up by less than the straddle price, then reverse down more than the straddle price, and you still wouldn’t have made a profit.

4) factor in fundamental news. At the time there was no apparent reason why Gateway options should have been so cheap. So, the straddle purchase seemed okay from a fundamental viewpoint as well.

The graph of GTW in the insert shows what actually happened after the GTW June 40 straddle was bought. At first, GTW moved modestly to about 45 (point “a” on chart). However, the move was reversed and the stock proceeded to fall about 9 points, to 36 (point “b” on chart). At this point, we had had a 9-point move, but it was of no avail since it went from above our strike to below it. Thus, no profits could be realized from that 9- point that was “within the box”. Another reversal in price occurred, as GTW rallied to 48 (point “c”), and then fell back again. By this point, it seemed as if the stock was merely teasing us, as nearly two months had passed and the stock had bounced around inside the “containment box”, ending up at about 44 (point “d”).

Finally, a breakout occurred, as marked on the chart. This was a strong move to new highs. At this point, I prefer to attempt to ride the trend. So all the puts were sold (to recapture whatever little value that remained) and half the calls were sold, too (to nail down some profits). The balance of the calls were held, riding the uptrend. Normally, I would use the 20-day moving average (or some similar short-term moving average) as a stop-out point, and just continue to ride the trend.

**Straddle Buying Strategy Results**

In conclusion, it might be interesting to look at the results of the straddle buying strategy, *as we have implemented it in the newsletter recommendations.*

Stock Options Futures Options # of positions: 28 25 # winners: 13 11 Avg. Investment: $2520 $4283 Avg. Days Held: 67 82 Avg. Profit: +$116 +$568 Avg. Annual ROI: 25.5% 58.8% Largest Gain: +$3555 +$11132* Largest Loss: –$1903 –$2622

We have been following the specific methodology outlined in this article since 1995. The results above are broken down into stock option straddles and futures option straddles. The “profit” column includes a commission of $8 per stock option or $15 per futures option (per transaction). The futures results are distorted by the substantial gain(*) that we had in a Swiss Franc straddle in early 1996. If we throw out that gain and also throw out the largest futures loss, we are left with an average annual ROI for the futures straddles purchases of 27.1% – much more in line with what we see from stock option straddle purchases. In addition, this is what I would intuitively expect to see from this strategy – overall profits in the 25% range.

In summary, the straddle buying strategy can be an attractive one – especially when one adheres to the four selection criteria described above, and when one allows his profits to run after the underlying breaks out.

*This article was originally published in The Option Strategist Newsletter Volume 7, No. 9 on May 14, 1998. *

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