Last Week’s Trade – Buying Straddles With Weekly Options

This is called buying a straddle.  If at any point on Friday, SPY changed in value by more than $1.00 in either direction, we could sell those options at a profit.  (At any price above $138, the calls could be sold for more than we paid for the straddle, and at any price below $136, the puts could be sold for more than we paid for the straddle.)

The market expected that 100,000 new jobs would be created, but the actual results were lower – about 80,000.  When the market opened up just over a dollar lower, it seemed not to be going anywhere so we took a profit, selling the puts for $155 each, collecting $1076.25 after commissions (the calls expired worthless and no commission was involved).  Our net gain on the trade was $235, or 27.8% on the initial investment.

We were hoping that the stock would reverse itself after the early drop so that we could sell the calls later in the day and add to our gain, but that never happened.

If we had waited until later in the day the profit could have been more than double this amount but if we had waited until the end of the day it would have been less.  There is no easy answer as to when to sell a straddle, but we will probably continue our strategy of taking a moderate profit when it comes along.  Another way to play it would have been to sell enough of the spreads to break even and let the others ride in hopes of a windfall gain.

Straddle buyers like volatility as much as we don’t like it in our other portfolios.  What they like best is a whip-saw market where the market moves sharply higher (and they sell their calls) and then down (when they unload their puts).   There are many ways to profit with options. Buying straddles when option prices are low and volatility is high is one very good way to make extraordinary gains.

The downside to buying straddles is that if the market doesn’t fluctuate much, you could lose every penny of your investment.  This makes it a much riskier investment than the other option strategies we recommend at Terry’s Tips.  

However, straddle-buying can be quite profitable if the current market patterns persist.  Right now, VIX (the so-called “fear index” that measures how high option prices are for SPY options) is at 17.10 compared to its mean average of 20.54.  This means that option prices are relatively low right now.  Last December, for example, when VIX was about 25, the same straddle we bought last week for $118 would have cost over $200.

On Friday, a SPY 137 at-the-money straddle with one week of remaining life (expiring July 13, 2012) could have been bought for $1.99 ($199 each).  If at any time during the next week, if SPY fluctuated more than $2, the straddle should be trading for more than $2.  Over the past 13 weeks, SPY has moved in one direction or another by at least $2 in 11 of those weeks, and in one week it fell by $1.94 at one point.

Straddle buyers like volatility as much as we don’t like it in our other portfolios.   There are many ways to profit with options. It is best to remain flexible, and use the option strategy that best matches current market conditions. Buying straddles or strangles when option prices are low and volatility is high is one very good way to make extraordinary gains, as we happily did last week.

The downside to buying straddles or strangles is that if the market doesn’t fluctuate much, you could lose every penny of your investment (although if you don’t wait too much longer than mid-day on the day options expire, even out-of-the-money options retain some value and should be able to be sold for something).  This makes it a much riskier investment than the other option strategies we recommend at Terry’s Tips.  However, straddle- or strangle-buying can be quite profitable if the current market patterns persist.