From the November 2013 issue of Futures Magazine • Subscribe!

Trade movement using a strangle or a straddle

Gold is going to move; we know that. It’s the direction that can be the problem. Through government shutdowns, rising interest rates and geopolitical impacts to the U.S. dollar — just to name a few — investors constantly are trying to figure out the direction of gold.

If wrestling with the direction of precious metals isn’t your strength, then move from directional to non-directional trading. Using GLD for example, you can trade the movement, regardless of direction. This is done by buying either a strangle or a straddle.  

Both strategies involve buying a call and a put. A straddle combines the two options at the same strike price while a strangle involves buying out-of-the-money calls and puts. Here we’ll assume the use of a straddle.

The idea for either strategy is the same: Get enough movement so the profit of one option outweighs the loss of the other, thereby netting a profit. If gold rallies, then the call profits, but the put has limited loss. If gold tanks, then the opposite happens, with the put producing the profit while the call has limited losses.

Sounds easy, right? If gold moves up or down, you win. But it’s not quite that simple.  You can get hurt in a couple of ways with this trade.  

First, because the trade involves buying two options, it now involves a time decay problem if the underlying doesn’t move. Second, a drop in the implied volatility hurts this trade and can overshadow any movement that otherwise might have led to profitability.  

Understanding two key elements can mute these risks and help you find potentially profitable trades without having to guess direction correctly. Sometimes a decent move is preceded by common consolidating wedge or pennant patterns. Thus, the first element is to look for these patterns, as in the chart to the left.  

Pattern A preceded a fairly substantial drop over the next several trading sessions, which is the kind of movement that can produce profits with non-directional strategies. Pattern B also preceded a good move.

But the second element also has to be present:  Low implied volatility. Volatility, shown in the lower chart, is the key. If the volatility is low and doesn’t move much lower, then the only thing you really have to worry about is time decay.  

In the above example, the implied volatility is near the low end of its recent range for both patterns A and B. Here’s a straddle trade example for pattern B.

With 30 days until expiration and GLD trading at $123.32, the at-the-money (123) straddle is worth $6.00. The implied volatility isn’t at its absolute lowest, but the risk of loss to a volatility crush is not significant.  

Notice also that on this date, the stock appears to be breaking out lower, but quickly reverses and five days later is trading nearly $5 higher at $128.24. That’s a good reason to consider a non-directional trade rather than trying to guess the start of a trend. With this move in the stock, the straddle has increased to $7.55, generating a 26% profit for the straddle buyer.

Once GLD moves, then close or adjust the trade, and look for another potential opportunity. But keep in mind the two keys: Look for consolidation patterns that might precede a move, and make sure that the implied volatility is low. Now you don’t have to pick the direction as long as gold moves enough.

Greg Loehr is a former CBOE market maker trained by Susquehanna Intl. Group, and founder of the education firm OptionsBuzz.com.

Comments
comments powered by Disqus
Check out Futures Magazine - Polls on LockerDome on LockerDome