For most of the last year, the market (SPY) and many individual stocks have fluctuated more than the implied volatility of the options would predict. This situation has made it quite difficult to make gains with the calendar spread strategy that we have long advocated.
Now we are experimenting with buying straddles as an alternative to our basic strategy. This represents a total reversal from hoping for a flat market to betting on a fluctuating one.
Today I would like to report on a straddle purchase I made last week.
Another Buying Straddles Story
I selected the Russell 2000 (Small-Cap) Index (IWM) as the underlying. For many years, this equity seems to fluctuate in the same direction and by about the same amount as the market in general (SPY) although it is trading for far less ($80 vs. $134) so the percentage fluctuations are greater.
On Monday morning, IWM was trading right about $80. I bought an 80 straddle using IWM (Jul2-12 puts and calls), paying $1.53 for the pair. If IWM moved by $1.53 in either direction, the intrinsic value of either the puts or calls would be $1.53, and there would be some time premium remaining so that either the puts or calls could be sold for a profit.
How likely was IWM to move by more than $1.53 in either direction in only one week? Looking back at weekly price behavior for IWM, I found that in 62 of the past 66 weeks, IWM had fluctuated at least $1.60 during the week in one direction or another. That is the key number I needed to make the purchase. That meant that if the historical pattern repeated itself, I could count on making a profit in 94% of the weeks. I would be quite happy with anything near that result.
Buying a straddle fits my temperament because I was not choosing which way the market might be headed (something I know from experience that I can’t do very well, at least in the short term), and I knew that I could not lose 100% of my investment (even on Friday and the stock had not moved, there would still be some time premium remaining in the options that could be sold for something).
One on the biggest problems with trading straddles is the decision on when to sell one or both sides of the trade. We’ll discuss some of the choices next week. What I did was place a limit order to take a reasonable profit if it came along. When IWM had fallen about $1.75, I sold my puts for $1.85 on Thursday. On Friday the stock reversed itself, and I was able to collect $.17 by selling the calls, making a total 20% after commissions for the week. Not a bad result, I figured.
At some point during the week, there were opportunities to sell both the puts and calls for more than I sold them for, but I was delighted with taking a reasonable profit. You can’t look back when trading straddles. If I had not sold the calls but waited until the end of the week, I would have lost about 70% of my original purchase. So selling when you have a small profit is clearly the way to go.