Thursday, July 13, 2006

Trading P.I.T. Session 3

Tonight's Trading P.I.T. class with Bill Keevan covered the Straddle/Strangle option strategy. This is a neutral debit strategy where you make money if the stock moves either up or down. Without covering the specific guidelines TMTT teaches for entry and exit, the basic idea is that you buy a Put and a Call before expected volatility in a security. Of course if you think really hard about stock behavior, you may be able to predict increased volatility around specific, predictable events. I'll let you think about which events repeatedly produce such an increase in volatility so you feel like you've earned the answer.

This strategy is one where you can make money, typically 100% of what is at risk in the trade. However, if the stock does not move, you stand to lose money. It's important to make a distinction between how much is risked versus the total cost of the trade. We won't be risking the total cost because we'll only be holding the Call & Put for approximately 1/4 of their expiration time. Hence, if the stock's volatility decreases and it just consolidates or trades sideways, we will primarily be risking the decrease in value of the Options due to lower volatility. Option value is derived from volatility, so if there is a decrease in volatility the value of the options that we've purchased will also decrease. Theta decay (time decay) will also account for some of the money at risk.

I know this sounds fantastic, right? Make money no matter which direction the stock goes!?! It is a very cool trade, but let me tell you that there are a number of aspects that you need to pay attention to in order for this trade to work, and if you don't know the guidelines you can easily spend too much on the trade relative to the reward. You can also set yourself on a biased position instead of a neutral position. If you wanted to put yourself in a biased position, there are better trades to capture a directional move. As you would expect about pretty much any Option Strategy, you need to pay attention to the Option Deltas. This is a volatility trade and you must also take Implied Volatility into account. Also, like most trades, you need to take a look back into the history of an underlying security to help forecast the future to ensure your success. TMTT gives very clear guidelines for what the Net Delta should be for an ubiased position, as well as entry criteria based on Implied Volatility.

Tonight's class helped point us to some resources for identifying potential stocks to trade using a Straddle or Strangle Option Strategy. This isn't the easiest concept to grasp, but it shows just how powerful and flexible Options can be. I look forward to trading a Straddle/Strangle soon, but it seems this class was just a little late for taking advantage of this trade this quarter, however I will be looking for a current setup for this trade and hope to find one that will work for a paper trade. Stay tuned, it's starting to get interesting, isn't it?

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