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April 25, 2006

Traders Who Know Their Options Could Be Winning with a Straddle

By International Trading Institute

Sell 1 underlying having 100 positive deltas = -100 deltas Buy 4 options having positive 25 deltas = + 100 deltas Puts would be exactly the opposite. Because puts have negative deltas, you would purchase one underlying as opposed to selling it. You can also hedge options with options. For example, if you purchase 10 out-of-the-money calls, each call having a delta of +40, your delta position is +400. You could hedge your delta risk by purchasing 8 at-the-money puts, each having deltas of 50, or 400 deltas total, thus netting you a delta position of 0. The point being made here is that regardless of the number of calls, puts or underlying, the position can remain delta neutral, if the positive and negative deltas offset each other. In summary, a straddle accumulates long deltas as the underlying increases in value, and accumulates short deltas as the underlying decreases in value. Let's put this to practice. This time lets say you purchased the DEF 50 straddle with the stock trading at $50 and 52 days until expiration. You paid $3.10 for the 50 call and $2.50 for the 50 put, therefore you purchased the straddle for $5.60. The volatility is 30. It's two weeks later. Let's assume the following: *The stock is trading at 45 *Volatility remains at 30 *The put is trading at $6.25 and the call is trading at $1.00 *The put has a delta of 70 and the call has a delta of +30, therefore you have a net delta position = 40. You could purchase 40 shares of DEF (giving you +40 deltas), making your position delta neutral. This would mean that at expiration the straddle would be worth at least $200. If the stock is at $50 on expiration, the call and the put would both expire worthless, however you would make $5.00 on every share of stock, or $200 (40 x $5.00). Your net loss on the position would be limited to $360 ($560 - $200). This would be your worse case scenario. What if the stock closed at 54 at expiration? The put would expire worthless, the call would be worth $400, and the stock would make $360. Your position would now be worth $760, resulting in a net profit of $200. Consider if the stock dropped to 42 at expiration. The call would expire worthless, the stock would lose $120 (40 x $3.00), and the put would be worth $800. Our total profit would then be the value of the in the money put at expiration less the initial cost of the straddle less the loss on the stock purchased at $45, $70 ($800 $560 $120). You would continue to keep rebalancing your deltas by purchasing the underlying as the delta decreases, and selling the underlying as the delta increases, generating profits regardless of whether the straddle expires worthless, either reducing your overall cost of the straddle or adding profits. The management of deltas can also be done by selling calls as the underlying moves up and selling puts as the underlying moves down. The process of rebalancing the deltas of a straddle is called Gamma Scalping and will be covered in a future lesson in greater detail. The overall idea that we hope to convey about the straddle is that it offers many opportunities to be profitable, if all risks are fully understood and properly managed. Options are sophisticated investment vehicles and are not suitable for all investors. If you are considering trading or investing using straddles or strangles, we advise you to consult with a tax advisor as to how taxes will affect the outcome of the contemplated option transaction. To receive a copy of the Options Disclosure Document, please contact Karen Johnson at International Trading Institute, Ltd, 311 South Wacker Drive, Suite 3800, Chicago, Illinois 60606 (312 986 2000).