To my knowledge, there is no perfect system. Every trading method has losing scenarios, and this includes the scantily clad straddle. There are two basic situations where the trade loses money: Gaps and whips.
With a price gap, the market jumps past your stop and executes you at a worse price than you were expecting (see "Leaping to losses," below). In the chart, the market gaps past the 1025 buy stop and gets filled at 1041. This additional 16 points from the original stop costs you $800 more on the trade. In this situation, the trade still made money ($450) because the put expired worthless and you kept the entire $1,250 premium. But if it had opened at, say, 1060, the entire trade would have been at a loss. Because of this risk, it’s advisable not to use this strategy with commodities known to have locked limit days, such as lumber, hogs, corn, etc. It works best with liquid markets like the E-mini S&P 500.
Another scenario that ends in a loss is a whip trade. This occurs when both buy and sell stops are hit. When the second one is hit, then the entire trade is exited. This involves buying back the straddle. The resulting loss is dependent on how much time premium is left in the options. The earlier the whip occurs in the trade’s life, the bigger the loss, as opposed to a whip occurring with only 10 days remaining in the option’s life.
The most catastrophic situation is a whip with double gap fills beyond each stop. This would be an extremely rare occurrence, but it still must be considered a possibility as you evaluate this strategy.
Finally, because stop orders are being used, there will be times that you’ll get slippage (the order is filled at worse than your stop price). If, on expiration day the futures price closes near the strike, it may not be clear whether the option will get exercised. You don’t want to come in on Monday thinking you had a profitable trade only to find out you’re long the S&P 500 and it dropped Sunday night by 50 points. Sometimes, it’s better to buy back at least one leg of the option right before expiration just to avoid this scenario.
Be sure to cancel the related standing stop orders when the trade is completed. Also, if the futures month is not expiring, then the option is not a cash settlement, but the option is exercised and you’ll be long or short the underlying commodity.
There are situations in which the price might close just in the money for the option, but is not exercised. This happens because the option owner has several hours to make up his or her mind on whether to exercise the option. In after-hours trading, the commodity might move against the option owner to where it’s not profitable to exercise. When the price is close to the strike, it is best to exit the position. It will cost you a little, but will provide some peace of mind.
In Treasury bonds, the strikes are in full handles (129, 130, 131, etc.). The options trade in 64ths. T-bond futures trade on a quarterly cycle: March, June, September and December, but include serial options that trade every month. The November options are based on the December futures. Options expire the month before, meaning the November options expire in October.
In mid-September, the November T-bond option straddle with a strike price of 130 was sold. The December T-bond futures contract, the underlying for the November options, was trading around 129-28/32. The premium collected was 2-17/64 for the call and 2-23/64 for the put. This resulted in a total collected premium of 4-40/64, or $4,625. Once filled, two stop orders were placed:
- Buy one December T-bond futures at 132-09/32 stop GTC
- Sell one December T-bond futures at 127-20/32 stop GTC
The placement of the stop was equal to the distance of the strike price and the premium collected: Call premium of 2-17/64 plus 130 strike for a buy stop of 132 9/32; then 130 strike minus put premium of 2-32/64 for a sell stop of 127-20/32.
A few days later, the bonds moved higher and hit the buy stop at 132-09. The bonds continued their climb to 135-12. During this phase, we’re pretty happy with the trade. The call has been covered by the long position. If the bonds stay above the strike price of 130, now five points away, the trade will be profitable. Then the price started dropping and returned to the high 130 area. On November options expiration, December T-bond futures closed at 131-20. The results were as follows:
Sold: 2 17/64
Expired: 1 40/64
P/L: +41/64 (+$640.63)
Sold: 2 23/64
P/L: +2 23/64 (+$2359.38)
Long: 132 9/32
Exit: 131 20/32
P/L: -21/32 (-$656.25)
Call option: + $640.63
Put option: + $2,359.38
Futures trade: - $656.25
Total P/L: +$2,343.76
Other elements can be calibrated to fine tune the strategy, such as time frame and volatility. However, this basic concept is straightforward and successful.
Robb Ross runs White Indian Trading Co., and developed its Stairs trading program (see "Ross: White Indian and rubber chickens," August 2010). He is an experienced programmer and system developer, having worked at both Microsoft and NASA.