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September 28, 2006

All Straddles Aren't Equal: A way to make money in any market

By Mark Longo

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  • All Straddles Aren't Equal: A way to make money in any market
  • Page 2

Retail options investors, despite years of the options industry's educational efforts, still lack the sophistication of institutional investors. That's understandable: One's a pro, the other isn't. Indeed, you're probably aware that fly-by-night operators have begun exploiting the retail options investor's shortcomings. They are using the flexibility and power of options to lure unsuspecting customers who don't understand the options game.

A Bad Taste

Anyone with a television and a computer can see this. I'm speaking of late-night infomercials, spam emails, bait-and-switch websites and fee-based seminars. These flimflams tout how traders can use options to make money in any market environment.

All one needs to do is buy a software package/trading system/newsletter.

The investor, this moonshine message continues, will then make money regardless of the investment's underlying moves. It couldn't be easier!

Judging by the amount of questions I've fielded, it is a tactic that is targeted beyond retail customers. A surprising number of unscrupulous brokers and investment houses have used variations of the same pitch, luring institutional customers into options, too.

This approach raises two questions: Can options really deliver on these outrageous claims? And are these pitchmen just selling snake oil?

Up, Down, Sideways

What is this magical trading technique that allows traders to profit no matter which way the underlying stock moves? Well, it's actually a very simple strategy that has been a mainstay of the options world for decades. It's called a straddle, and it is the heart and soul of all these late-night moneymaking schemes. Straddles involve buying or selling a call and a put on the same strike. Since most of these strategies involve buying at-the-money straddles, we'll focus on those for now.

Combining a call and a put from the same strike is the basic idea of the straddle. It is also the hook behind all of those spam emails and infomercials. As the ads claim, this position does indeed gain value no matter which way the market moves. It's a powerful concept and one that seems like magic to the options layman. Unfortunately, there are significant downsides to this position that the infomercials neglect.

The Downside

Despite what the hucksters would have you believe, straddles are not a magical path to profitability in options. If these positions performed as touted, there would be little reason to trade anything else. Unfortunately, as with everything in life, the benefits of straddles are balanced against a number of significant drawbacks. The first and most obvious drawback is cost.

Since you are buying two options on the at-the-money strike, you are paying twice the amount of the implied volatility premium when compared to purchasing only a single option. As a result, the trade requires a much larger movement in the underlying instrument just to break even. Since the break-even point is a major consideration in any trading decision, this is a significant drawback.

Another significant downside to trading straddles is theta, also known as time decay. Each option has an expiration date. As it inches toward that date, it loses a little bit of its extrinsic value (volatility premium, interest, etc).