How to Master This Misunderstood Part of Options Trading
Last Friday, the unemployment report was released.
The previous day, there was this feeling in my gut that it would move the market. That there was a significant trade opportunity.
I let my editors know in advance that the day’s True Options Masters dispatch would come in hot on Friday morning.
Then that morning, I rushed to review the report and find a trading opportunity to share with you…
As I analyzed the market’s reaction to the report, one trading strategy for the day jumped out. A straddle offered almost-certain profits.
Everyone on the team was standing by to get the email to you by our 11 a.m. deadline.
We compressed a process that usually takes a day into less than three hours…
And I’m glad we did. By the end of the day, the trade I recommended delivered a gain of as much as 76% to those who took it.
There’s no better proof, in my mind, that the straddle is an essential tool for options traders.
So today, I want to dive deeper into the strategy. I’ll show you the key reason why it works, and set you up to profit when similar situations arise.
The Misunderstood, Key Factor of Options Trading
The straddle worked last Friday because markets were volatile. Straddles are a trade on volatility.
Now, most trading strategies involve a directional move. If you believe prices are going up, for example, you can buy a call option. Traders expecting a price decline would buy puts.
Many traders, especially new traders, believe this to be the extent of options trading complexity. Unfortunately for them, it’s not quite so simple.
Volatility is an important and misunderstood factor in options prices. Volatility premiums can often account for more than half of the price of an option. It’s not just about direction.
This isn’t a bad thing. In fact, this volatility aspect is one of the lesser-known benefits of options. And there are strategies for trading volatility in addition to price.
Here’s what I mean…
When volatility is high, the dollar amount of this premium is high. As volatility declines, the premium falls. So, selling a high-volatility premium is a way to benefit from the decline in volatility.
For example: If you think prices will go up and volatility will decrease, it could be best to sell (to open) a put option. By selling a put option in this scenario, you can benefit from both the price move AND an expected decline in volatility. If the put option expires worthless, you would keep all the premium you sold the option for.
Options can also be used to trade volatility when you don’t have any opinion on the direction of the price move. As we proved last Friday, a straddle is one way to do that.
An Options Strategy That Benefits From Volatility
With a straddle, you buy a call and put with the same strike price and same expiration date. Last week, I recommended buying the July 2 $356 call and the July 2 $356 put. Both options expired that day, and both shared the $356 strike price.
That trade would cost less than $150 to open with the call trading near $0.70 and the put at about $0.80.
As I wrote then:
“If QQQ closes above $357.50, the trade will be profitable at that entry price. The trade will also be profitable if QQQ closes below $354.50. Between those two prices, the trade will have a loss. The maximum loss on the trade is the price paid to open the position. The maximum gain is significant if there is a large rally or sell-off today.”
At the close, QQQ was at $358.64.
The put was worthless, but the call was worth $2.64. That was a gain of $1.14 on the entry price of $1.50.
Straddles are often used for days like last Friday, when an unemployment report is announced. There are always options expiring that day, so the cost of straddles is typically low.
That’s also a useful strategy for other economic news releases. For individual companies, straddles are also effective when earnings are announced, or for biotech companies when news about clinical studies are due.
You don’t always have to know what direction a stock will go in order to trade options on it profitably. This is such a hugely misunderstood aspect of trading that I wish more people knew.
We’ll continue monitoring events like these and recommending similar strategies when the time is right.
Of course, we’re not just here to “give you a fish.” We’re here to “teach you to fish,” as well.
So I’d suggest employing this strategy yourself, the next time you spot a similar opportunity. If you’re new to trading, just try it with one contract or two. Get a feel for how it works.
And once you do, I’d like you to write me with your story — whether the trade worked or not.
Michael Carr, CMT, CFTe
Editor, One Trade
P.S. Earnings season is here. It’s a great time for you to test out this straddle strategy.
Of course, this is a fairly speculative way to go about trading options on earnings… So, keep your position sizes small.
Chad, on the other hand, has a more conservative earnings trading strategy. He cuts out 98% of the stock market and only focuses on names that produce consistent patterns AFTER earnings. Then he waits for the dust to clear and trades the longer-term trend.
It’s a proven strategy, with quite a few triple-digit winners on the books. Learn more about it here.
Chart of the Day — Generals Alone Can’t Win Wars
By Mike Merson, Managing Editor, True Options Masters
Today’s chart comes courtesy of your editor, Michael Carr, who’s noticed a startling divergence in the stock market…
The pink line in the chart above is the level of the SPDR S&P 500 ETF (NYSE: SPY). The blue line is the NYSE Advance-Decline (A/D) line, which measures the difference between stocks in the NYSE climbing and those falling. When the line rises, more stocks in the market are rallying than falling — and vice versa. (Michael also smoothed out the action in the A/D line by plotting it as a five-day moving average.)
In strong uptrends, these two lines tend to rise together — as more stocks participate in the broad market rally. But that’s not what we’re seeing today.
The level of SPY has broken away from the A/D line. That means fewer stocks are participating in the broad market rally. Michael put it best in an email he sent me:
“Big divergence with SPY this month. Generals can’t win wars unless the troops rally behind them. A/D line is weak while generals (SPY) rush on. Something’s gotta give.”
We’re spotting lots of reasons to be cautious this week, from major tailwinds for the dollar to surges in volatility. And we saw this manifest in yesterday’s action, with the S&P 500 falling close to 1%.
Buying some protection in the form of puts, or trimming some gains off of your winning stocks, are good moves to consider right now.
Managing Editor, True Options Masters