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April 25, 2006

Traders Who Know Their Options Could Be Winning with a Straddle

By International Trading Institute

*The price of DEF has basically remained stable, and therefore the implied volatility has decreased. Moreover, time decay (theta) has begun to take its toll. You decide to reassess the situation and you still believe that the 60 straddle is worthwhile. You have a couple of choices. You can leave it alone, as you do still have four weeks left to see the movement you need. Or, you could roll the position to a month further out, thus giving DEF more time to experience the move you predict. To do this you would simply sell out the call and the put in the current month and reinitiate the straddle in a more distant month. *Now let's say that instead of DEF remaining stable, it had dropped three dollars. You could consider rolling down just the put. You would lock in a profit on the sale of the original 60 put, and select the new put by evaluating the current degree of bearishness, as well as the volatility of the puts you are considering buying. By purchasing a put with a new lower strike, for example the 50 put, this would create an entirely new position. You would no longer have on a straddle, you are now long the 50/60 strangle. Managing The Data Let's consider another alternative you have for managing a long straddle position. In this segment, we will show you how to help generate income through the dynamic rebalancing of deltas at key intervals using stock. With a straddle, profitability may not depend on movement of the underlying at all. If constructed in a theoretically sound manner, a straddle will have deltas that approach zero as they near expiration. If you are not familiar with delta, you can think of it as the "chance or probability of the option expiring in-the-money. Calls have positive deltas and puts have negative deltas. Therefore, the idea behind a classic straddle is to keep your position "delta neutral". An understanding of delta is essential if you wish to establish a stock equivalent hedge. Delta is technically the measure of the sensitivity of an option's value with respect to changes in the price of the underlying. The delta of stock can be considered 1 (or 100%). This makes sense because if the stock moves up $1.00 higher from the price it was purchased, you make $1.00 or 100% percent of the movement. If you are long then you have long delta. A positive delta expresses the direction you wish the underlying to move. Conversely, if you are short stock, you have negative delta. As in-the-money options expand to 100, out-of-the-money options decrease to 0. Options can have either negative or positive deltas; however, the deltas cannot be greater than 1 (or 100%) of the movement of the underlying. Remember that option premiums are derived from the price of the underlying. Because a long call gives you the right to purchase stock, thus having a positive market exposure, they have positive deltas. Call option deltas range from 0 to 100. At-the-money options have roughly a 50 delta. In-the-money options will have a delta greater than 50 and out-of-the money options will have a delta of less than 50. As an example, if a 100 DEF call has a delta of 50, then for every $1.00 move in DEF, the premium of the 100 call will change by $0.50 or 50 percent of the movement of the stock. If the DEF 100 calls had a premium of $10.00, with the stock trading at 100, the premium would increase from $10.00 to $10.50 with a move in DEF from 100 to 101. Since a put is bearish, it will have negative deltas. Put deltas will range from 0 to negative 100. As the underlying moves down in value, put options increase in value and therefore have negative delta exposure. A DEF 25 put with a delta of 70 will move $0.70 with a one-point move in the underlying. If the stock moves from 22 to 21, the option premium will increase by $0.70. If DEF moves from 22 to 23, the option premium would decrease by $0.70. Option deltas can be affected by other factors such as time and volatility. In-the-money options expand toward 100 the closer expiration nears. As the in-the-money options expand to 100 the out-of-the money options' deltas decrease to 0. Options with longer maturities and the same strike will have deltas closer to 50. For example, a call with a strike of 90 and 20 days until expiration has a delta of 99. A call with the same strike of 90 and 200 days until expiration has a delta of 78, which is closer to 50. Since we know that stock always has a delta of 100, to determine your underlying stock equivalent, you simply divide the stock's delta (100) by the option's delta. For example, if your option has a delta of 25, your result would be a 4:1 ratio. This means that you would need to sell one underlying for every four options contracts that you purchased. For example: