In previous articles, we developed the premise that we need to build stability into our trading business. We discussed using a specific strategy; straddles; for that purpose. The main idea was to find a stock oscillating equally as long and far above AND below a specific strike price. Once found, we'd allow the stock to get to that strike price, then buy a put and a call with that specific strike price and about 4 or 5 months of time prior to expiration.
Pulling Profit From Stability Trades
Using a straddle to establish a position wherein the initial value remains relatively constant is a great way to induce stability (and safety) into your trading business. The question then becomes how to pull profit from these positions without having to give up the neutrality of the straddle. The simple answer is . . .you can't! But there is good news here:
Follow along on the chart above. If we buy a May $55 put and a May $55 call when the stock price is at or very near $55 (1/27/04), paying say $5, we have about $10,000 invested in a position consisting of 10 contracts. Follow the chart as the stock moves down. We can reasonably expect the option premium to change in value as the stock moves. For example, around February 2, the stock has fallen to around $50. Those puts we bought for around $5 are now worth around $9 or $10. However, the calls we bought for around $5 are now worth around $1. No matter, we said last time that the POSITION value is still worth around $10,000, what we PAID for it! So, even though the stock has fallen significantly in value, our STABILITY money is still there, ready to be used in an emergency. In other words, we could close the position and take our initial investment back at ANY time we wanted or needed to do so... as long as we own BOTH the calls and the puts. Here is where the risk enters ... Sell the puts for that profit when the stock has touched the bottom line then moved back up (see 2/6/04). You are now totally directional in the trade ... BULLISH (you own the May $55 calls). Having purchased those calls at $5, you still have $5 at risk and are UNDERWATER to boot! But wait ... take a much more focused look at that.
You bought the puts for $5 and just sold them at $9, a $4 profit. You bought the $5 calls for $5 and they have deteriorated to around $1, $4 underwater. Check it out ... you're not as bad off as you think you might be! The $4 profit on the puts entirely offsets the $4 loss on the calls. That leaves $1 unaccounted for. THAT is what you have left at risk here! You entered a $10,000 position and have just pulled $9,000 off the table but retained fully 1/2 of the original position; a position which is totally directional - UP! Continue to follow the stock price.
Notice near the end of February, the stock price has risen to around $60. At that time, our calls have risen to be worth around $9 . Again, we see that our emergency money has been intact all along, our most depressed value at any time was just after we sold the first group of options; the puts. Use the chart above to pick out the many OTHER times you could have made this same trade.
The Risk - The Reward
Up to this point, we've discussed the importance of having some emergency cash set aside. That concept, when followed, can be priceless. Additionally, we've learned about how straddles work and we've seen how the strategy produces a 'safe-haven' for some of your "stability" cash. Before trading real money in this way, however, please practice these trades. Keeping in mind where you find the risk and where you find the reward in a medium term approach to balanced straddles.
Notice that we entered the position when the stock was AT the strike price. We had ONE entry, followed by TWO exits, selling to close each option position as the stock hit maximum oscillation (up or down) then turned. Follow that sequence each time you enter ... Get In - Get Out - Get Out. When you first get in, you are at your highest level of safety. When you exit the first option, you are at you highest level of risk. The potential profit here is limited only by the stock price oscillation, and your patience and willingness to allow the trade to come to you, rather than chasing less than optimum profits!
There is so much more which could be said regarding this approach to medium term balanced straddles. We don't have the time or space for it here, but join us in the trading lab and work extensively with us on mastering the trade!
We'll cover the most time-intensive method; short term straddles, next time in part VI. See ya then!
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