Option strategies that limit your risk: Buy a Straddle

Technically, buying a straddle means buying a call and a put with the same strike price and the same expiration month. If you buy a call and a put with different strike prices, this is technically referred to as buying a strangle. For our purposes, we will use the phrase "buy a straddle" to describe both strategies. An example of the Buy A Straddle strategy would be as follows: On 8/28/96, Intel was trading at 81.25. A trader could have purchased the October 1996 85 Call option at 2.50 and the October 1996 80 Put option for 2.88, for a total of $538 dollars. If this position was held until expiration, the trader has unlimited profit potential if Intel closes below 74.62 or above 90.38. If the positions are held until expiration and Intel closes between these two price levels, the trader will experience a loss.

Example:

Buy 1 ABC May 60 Call @ 3
Buy 1 ABC May 60 Put @ 2

The trader will pay a combined premium of $500. As shown in the graph below, the trader will profit if the market price goes above $65 or below $55. The entire $500 will be lost if ABC is exactly $60 at expiration.



In it's best light, Buying A Straddle is an excellent strategy for a trader who feels that a given stock or futures market is about to make a large move but isn't sure about the direction of the move. By buying a call and a put simultaneously, he has unlimited profit potential should the underlying make a large move in either direction. In it's worst light, Buying a Straddle can be considered the worst of all worlds. You pay two option premiums plus two commissions, the underlying market absolutely has to make a fairly substantial move in one direction or the other in order for you to simply break-even, and you lose time premium every day, not just on one position but two. In general, anything less than a major market move will leave you with a loss when buying a straddle. The key when buying a straddle is to stack as many favorable variables in your deck as possible and to avoid the obvious pitfalls, which reduce your chances of making money.

The keys to making money when buying straddles are:

A. Selecting the right options to buy. If you buy options that are far out-of-the-money the probability of one of the options eventually trading in the money is extremely low. Thus time decay begins to eat away at the price of your options. If you buy options too close to the money, it increases the move that the underlying needs to make in order to generate enough profit on one option to offset the loss on the other option. Your best bet is usually to buy the best priced near-the-money options.

B. Buy only when implied volatilities are low. If you buy a straddle when volatility is high, you put yourself in a situation where the underlying stock or futures contract absolutely has to make a major price movement to have any hope of making money on the trade. For this reason you should only consider buying a straddle when the Relative Volatility for the market in question is less than 3.

C. Buying options with plenty of time left until expiration. While these options cost more to buy they give you a higher probability of making money by giving the market more time to make a move and also by delaying the negative effect of time decay. Ideally, you should buy options with at least 45 days left until expiration when entering a straddle. Once you have entered a trade following steps A, B and C and have decided how much you are willing to risk on the trade, you must then be patient and give the underlying stock or futures market time to move. If the underlying fails to move and the option prices fall and you get stopped out with a loss that is simply part of trading. However, if you decide to exit the trade simply because you are getting impatient waiting for the underlying to move, that is a mistake. As long as you have entered the position with adequate time left until expiration, do not be too quick to change your mind.

When To Exit Long Straddle

Exiting at a Loss
Determine before entering the trade if you will hold until expiration or cut your loss at some point. If you are planning to cut your loss, then determine the maximum downside risk on the trade (which is simply the amount you paid to purchase the options) and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then exit entire position.

Exiting at a Profit
Choice 1:

1. If you are trading only one call and one put, then:
   
2. If one of the options bought doubles in price, set 1/2 of your remaining open profit as a trailing stop. Raise trailing stop as profits keep rising.
   
3. If one of the options bought triples in price, close all positions.
   
4. If one of the options bought goes 3 strikes in the money, close all positions.
   

If you are trading more than one call and one put, then:

1. If one of the options bought doubles in price, sell half of your position and set 1/2 of your remaining open profit as a trailing stop. Raise trailing stop as profits keep rising.
   
2. If one of the options bought triples in price, close all positions.
   
3. If one of the options bought goes 3 strikes in the money, close all positions.
   

Most traders tend to overstay their welcome when buying straddles. The popular notion is that you have to "hit a few home runs" to make up for some of the 'strike outs". So when a trader gets a large profit on one side of a long straddle he will often hold on and hope for a huge winner to develop. More often than not this does not happen and a decent profit often turns back into a loss as the market reverses, time decay eats away at the option prices, etc. The trading rules detailed above for exiting a long straddle at a profit are designed to take profits when they are available and do not generally wait around for "the big score".

Option strategies that limit your risk: Buy a Calendar Spread

The primary reason for entering a Calendar Spread is to take advantage of disparities in volatility between near-term options and options of a deferred month. By selling a short-term option with a sharply higher volatility than a longer-term option of the same strike price, a trader can establish a position that can be profitable over a wide range of underlying prices. You should only enter a Calendar Spread if volatilities warrant their use and you feel confident that the underlying stock or futures market will remain in the profitable range.

For example, say XYZ stock is trading at 65 in March. The May 65 strike put option is trading at 14.50 with an implied volatility of 24. At the same time the August 65 strike put option is trading at 18.75 with an implied volatility of 20. The near-term option (May) is trading at a volatility that is 20% more than the longer-term (August) option. The price of the May option in this example is comprised solely of time premium. As expiration nears, this time value will decay to zero. While the August option will also lose some time premium, it will not lose nearly as much as the near-term May option. This trade will show a profit at expiration if the price of XYZ stock is between approximately 40 and 109. Outside of this range, losses will occur. The profit/loss graph of a call calendar spread has the same general characteristics and shape as the put calendar spread



For example, say XYZ stock is trading at 110 in August. The September 110 strike call option is trading at 5 with an implied volatility of 24. At the same time the October 110 strike call option is trading at 6 with an implied volatility of 20. The near-term option (September) is trading at a volatility that is 20% more than the longer-term (October) option. The price of the September option in this example is comprised solely of time premium. As expiration nears, this time value will decay to zero. While the October option will also lose some time premium, it will not lose nearly as much as the near-term September option. This trade will show a profit at expiration if the price of XYZ stock is between approximately 104 and 118. Outside of this range, losses will occur.


As a result, traders must be prepared to cut their loss if needed when they enter a Calendar Spread. Calendar Spreads can be entered using at-the-money options or out-of-the-money options. Using at-the-money options (Type A Calendar Spread) is a "neutral" strategy, in that it does not require the underlying security to make a particular move in order to be profitable. Using out-of-the-money options (Type B Calendar Spread) does require that the market move in a particular direction in order to generate maximum profits. Type A trades offer a higher probability of profit by virtue of being approximately delta neutral.

When To Exit Calendar Spreads

Exiting at a Loss
Determine maximum downside risk and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then exit the entire position.

Exiting at a Profit

1. Inspect a theoretical profit/loss graph to determine price area of peak profitability.
   
2. If 80% of maximum profit is obtained, close 1/2 of your position and set 1/2 of your open profit as a trailing stop.
   
3. Raise trailing stop as profits continue to rise.
   
4. If trading Type B (out-of-the-money) Calendar Spread and the underlying reaches peak profit price, exit the entire position.
   

Option strategies that limit your risk: Buy a Backspread

You may consider utilizing the Backspread strategy if a stock you are following suffers a sharp decline, and, a) you feel as though a bounce is imminent but, b) you are concerned that the sharp decline may continue. This is especially true if Relative Volatility is low and the volatilities for out-of-the-money options are lower than the volatility of the at-the-money option. Backspreads offer unlimited profit potential. Additionally, as long as a backspread is entered at a credit it allows you to profit even if your forecast is completely wrong. The tradeoff is that if the underlying stock drifts in a range, this position will lose money.

For example, say XYZ stock is trading at 96, the 95 call is trading at 4 and the lOO call is trading at 1. A trader could sell a 95 call at 4 ($400), buy 3 100 calls at 1 ($100 * 3) and take in a credit of $100. If the stock plunges and all the options expire worthless, the trader keeps the $100. If the stock rises above $100, the trader has unlimited profit potential by virtue of being long more calls than he is short. However, if the stock languishes in the 95-100 range, the 95 call will maintain its premium while the 100 calls will lose their time premium, thus resulting in a loss.

Example:

To set up a Call Backspread, say XYZ is trading at 96,
Sell 1 XYZ May 95 Call @ 4
Buy 2 XYZ May 100 Call @ 1

The trader will receive a credit of $200. If the stock plunges and all the options expire worthless, the trader keeps the $200. A loss will occur if the stock remains range bound between $97 and $103 with a maximum loss of $300 @ $100. If the stock rises above $103, the trader has unlimited profit potential by virtue of being long more calls than he is short.



Example:

To set up a Put Backspread, say CDE is trading at 187,
Sell 1 XYZ May 185 Put @ 5
Buy 2 XYZ May 180 Put @ 1

For this Put Backspread scenario, the trader will receive a credit of $300. If the stock rises above $185, the puts will expire worthless and the trader will keep the $300 credit. If the stock remains range bound between $182 and $178, a loss will occur with a maximum loss of $200 at $180. The long side of the trade will generate significant profits once the share price of CDE falls below $178.



When To Exit Backspreads

Exiting at a Loss
Determine the maximum downside risk and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then one should exit entire position.

Exiting at a Profit

1. If options bought double in price, set 1/2 of your open profit as a trailing stop.
   
2. Raise trailing stop as profits continue to rise.
   
3. If options bought triple in price, close entire position.
   

NOTE: If you are still holding this trade when there is one week left until expiration, you should exit this trade at that time regardless of whether you have a profit or a loss. This position can suffer greatly from time decay in the last week before expiration. If trade is held into last week before expiration and the underlying price drifts back into an unprofitable price range, a profit can quickly become a large loss.

Option strategies that limit your risk: Buy a Vertical Spread

A spread offers the trader the opportunity to limit losses on an option position in exchange for a limited gain potential. It involves the simultaneous purchase and sale of option contracts of the same class (puts or calls), on the same underlying security. The expiration month and/or strike price will be different. When a vertical spread is bought, the investor pays a higher premium for the option purchased than he receives for the premium of the option sold.

Example:

Buy 1 ABC May 80 Call @ 9
Sell 1 ABC May 90 Call @ 5

This spread is executed for a net cost of $400 (9 point premium paid � 5 point premium received). As shown in the graph below, the trader will profit if the market price goes above $84. The trader will maximize his profit at $90. The entire $400 will be lost if ABC declines to $80 or below at expiration.



The mechanics are exactly the same if a put spread is purchased as opposed to a call spread except the profit and loss regions are on opposite sides of the breakeven point as shown here:

Example:

Sell 1 ABC May 80 Put @ 5
Buy 1 ABC May 90 Put @ 9

This spread is also executed for a net cost of $400 (9 point premium paid � 5 point premium received). As shown in the graph below, the trader will profit if the market price falls below $86. The trader will maximize his profit at $80. The entire $400 will be lost if ABC stays above $90 at expiration.



Buying a Vertical Spread has several advantages and disadvantages in relation to buying a naked option. Among the advantages are:

1. Requires less capital to enter a trade (since you are taking in some premium for the option you sell).
   
2. Closer break-even point
   

The primary disadvantage to this strategy is that profit potential is limited. The primary reason for using this strategy is to take advantage of disparities between different options. You should buy a vertical spread ONLY if the option sold is trading at a significantly higher volatility than the option you buy.


When To Exit Vertical Spreads

Exiting at a Loss
Determine before entering trade if you will hold a losing trade until expiration or cut your loss early. If you are planning to cut losses, determine the maximum downside risk and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then you should consider exiting the entire position.

Exiting at a Profit
Maximum Profit (MP):

Calls:
a = (strike price of option sold -strike price of option bought)
b = (price of option bought -price of option sold)
Maximum Profit (MP) = (a -b )

Puts:
a = (strike price of option bought -strike. price of option sold)
b = (price of option bought -price of option sold)
Maximum Profit (MP) = (a -b)
Trade Period (TP) = Time until expiration.

Exit Rules:

1. During first half of TP, exit trade if 80% of MP is obtained.
   
2. During second half of TP, exit trade if 90% of MP is obtained.
   
3. Exit trade if price of option sold declines to .125 (stocks) or is worth less than $100 (futures).
   
4. If there are two weeks until expiration and you have a profit, you may consider placing a break-even stop to prevent an adverse price movement from turning a small profit into a large loss.