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http://www.optionetics.com/articles/article_full.asp?idNo=12480 28/07/2005 19:13:57

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Straddles and Strangles
By Guy Halpin, Optionetics.com
5/19/2005 10:30 AM EST
After attending the Optionetics 2-hour Workshop there was one strategy that
stuck in my mind - the straddle/strangle. As a Trading Tutor I speak with many
students and have noticed this is also a preferred strategy for them. After
hundreds of hours of study and many trades I have developed a system that I
have found to work quite well. The foundation of this system lays in the
Optionetics straddle/strangle taught at the 2-Day seminars with a couple of little
tweaks here and there.
Okay, lets step back and take a quick review.
a) A straddle is buying (going long) a call and a put which have the same
expiration month and the same strike price. (E.g. Buy 1 July 45 call on company
XYZ and buy 1 July 45 put on company XYZ.)
b) A strangle is buying a call and a put with the same expiration month but the
call has a higher strike price than the put.
Please note from here on in I will only refer to straddles however the exact same
system applies for strangles. As explained later, it boils down to your risk/reward
tolerance/expectations.
1) Straddles require a detonator - some kind of news to move the stock. This
could be earnings announcement, earnings reinstatement, FDA announcement,
clinical test results etc. The last two announcements are subject to high IV
where Optionetics Instructor Alex Mendoza has explored an interesting system
(see article Platinum Toolbox: The Method of the Skew Finder). I stick to looking
at stocks with upcoming earnings-generally 2-4 weeks out. This information can
be found at numerous Internet sites, including Optionetics.com. The earnings list
for 3 or 4 weeks out is copied and pasted into Platinum. Click on `List
Tools

`Edit Lists

Select List

give it a name (e.g. Earnings May 2-6) and

save. Platinum will only save stocks that are optionable. Now the earnings list is
saved I need to search the list to see which stocks have low IV.
2) In Platinum click on `Create Custom Ranker and set it up as follows in
screen shot 1.
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Figure 1: Custom Ranker Parameters
Click `Update to save these settings. Ensure in ranker name it has this ranker
loaded. Otherwise you will be searching the default parameters which will not
give us what we want. If it does not have the `Earnings ranker loaded select it
from the other rankers drop down menu and click `Replace.
3) Choose the stock list that you created in step 1 and click `ranking. This
ranker will now rank the IV of these stocks from bin 1 - bin 20. In straddles we
want stocks with low volatility (aka cheap options). The stocks from your list
with the lowest volatility will be in bin 1. To find out more on `bin ranking click
on this link IV bin list. Shortly a screen will appear with the template as below
(screen shot 2).
The Optionetics Trading Approach - Articles Page 3
http://www.optionetics.com/articles/article_full.asp?idNo=12480 28/07/2005 19:13:57
Figure 2: Optionetics Platinum output from Create Ranker
The use of Platinum has cut down the list from literally several hundred stocks
down to less than a dozen by simply creating a stock list and then searching this
list. (Note - The above list only has 4 because of the recent increase in volatility
in the market.) In addition, the list searched earnings for the week May 2-
6

the majority of companies release 1

st
quarter earnings in mid to late
March. I have shaded the `bin 1 stocks in grey to make it easier for you to see
however this does not appear in the Platinum output.
So by now there will be quite a few readers thinking `but I dont have Platinum,
what can I do? The cheap and quiet options lists is a good place to start. They
can be found at the Optionetics homepage. This doesnt give you stocks with
earnings coming up but it can still be used in conjunction with the following steps
to isolate straddle candidates.
So now we have a list of optionable stocks with low IV. The next step is to see if
the stocks in `bin 1 have a history of movements (I dont explicitly expect big
gaps on earnings announcement, rather some strong trends in the stock (either
way) with little range trading in a sideways direction).
4) To see if the stock is a `mover look at a 2 year chart. Optionetics provides
free charting where earnings are shown on the graph. There are also several
other websites out there that provide this information for free. Is the stock at/
near any key support/resistance areas? If so, this is a positive because the stock
is likely to either bounce off this level or penetrate it with strong follow through.
Look for a consolidation triangle as this is a good indicator that a break out is
imminent. A stock with a consolidation triangle back to back is an even better
sign (diamond). Example of this is Figure 3, below.
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Figure 3 - LNCR Consoidation Triangle (Diamond)
5) The list has been culled from several hundred candidates down to a couple
(if any at all). Next I look up the companys news to see of there is any reason
for this low. E.g. Takeover/merger announcement - in which case steer well
clear. This information is available from the Optionetics website. Yahoo finance
is another good one.
6) Now it is time to check just where IV is in comparison to the past. Look at
the IV graph for the past 18 months to see if right now the IV really is low for
this stock,
Does it have a cyclical wave? E.g. Screen shot 4 shows the 18 month IV chart
for PCLN.
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Figure 4 - PCLN IV
Notice the regular peaks in IV at earnings time.
7) The stocks remaining are serious contenders. Cross check the earning date
with another source to ensure the date is correct. Pull up the stocks options
chain to see what months are available. Generally I look for options with 50-120
days until expiration. I never enter a straddle using options with less than 50
days until expiration. This is the zone where theta starts hurting the
trade. Enter the trade into Platinum (I use `Create Trade) and analyse risk
graph.
Does the trade have enough time to move before hitting your maximum risk
tolerance? Is the prospect of this being a profitable trade realistic or does the
stock have to move too far? A little test I carry out now is to calculate the 2
month average movement of the stock over the past 2 years. Generally my
straddles are given between one and two months before my time stop is enforced
(if my profit exit has not been triggered). So the 2 month (over 2 years) average
should always be greater than the cost of the straddle.
8) Now I am clear on whether to trade this straddle or not. A few extra
pointers worthy of a mention include:

The stock price must be greater than $27.50. Stocks with a lower price do not
have enough downside room.

Average stock volume should be greater than 300,000. This rule can be varied
if the option strikes I am looking at have high open interest (>100). In general,
the higher the stocks volume the higher the options open interest.
9) To straddle or to strangle? Strangles are cheaper and usually offer a similar
risk graph is terms of breakevens. In general what I have found is although the
straddle costs more it provides a lower theta risk (time decay). However this
lower risk is accompanied by a lower ROI% should the stock breakout. It really
comes down to what you are personally comfortable with. Keep in mind if the
stock stays in a sideways range the time stop approaches strangles really start to
`feel the pinch so you dont want to be hanging around with 30 days (or less) to
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expiration. This is the absolute latest time stop I would ever use. Personally I
mainly trade strangles however do trade the occasional straddle when I feel more
comfortable with the risk graph.
A recent example of this was AZO. Back in mid Feb the 95 straddle could have
been entered for a debit of $920.
At the same time the 90/100 strangle could have been entered for $495.
After earnings the stock fell. The straddle was exited for a profit of $220 while
the strangle was exited for $225. The straddle had a ROI of 20% and the strangle
had a ROI of 45%. In net dollar terms the end result was the same however in
ROI the strangle was a much better trade. Had AZO traded in a sideways range
the % loss of the straddle would have been better than the % loss of the
strangle.
Problems going forward with this system
Using the `bin 1 scan we are only looking at stocks with IV in the lowest 5%
range of the past 6 months. A common question is how do I deal with IV
crush? Well, when the IV is so low for that stock the chances of it going lower
are minimal and it is for this reason it does not an issue.
This system has consistently produced dozens of `bin 1 stocks each earnings
period over the past year. However since mid April the increase in market
volatility has resulted in the stocks announcing upcoming 1
st
quarter earnings
with very few `bin 1 rankings. It is not to say that there are no good straddle
opportunities out there but this system will not produce the number of low IV
stocks as it has done in the past year if volatility remains higher than
previous. Perhaps a way around this is to include bins `2 and `3 as
candidates. (I just ran the scan on all optionable stocks and only 62 were in `bin
1!)
Entering a straddle/strangle when earnings is not within the next month
The only time I look at doing this is when there is a nice consolidation
triangle. Over the past year there have been some really nice triangles forming.
Here are a few for you to look at.
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Figure 5 - ABK Consolidation Triangle
Figure 6 - NVTL Consolidation Diamond
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Figure 7 - PFE Consolidation Triangle
Figure 8 - Consolidation Diamond
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For those of you who trade straddles/strangles I hope this article has helped your
education in some shape or form. I have tried to make it comprehensive and
accurate to the system I trade by.
Happy straddling!
Guy Halpin
Optionetics Trading Tutor and Contributing Writer
Optionetics.com ~ Your Options Education Site

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