A long straddle position can benefit on increased volatility in either direction, reports Dan Keegan.
Facebook (FB) is trading at $210.20 with 19 days left until the March 13th expiration date. The FB March 13, 2020 210 calls are trading at $5.90 while the 210 puts with the same expiration cycle are trading at 45.70 (as of Friday Feb.21). If FB closes at $210.20 on March 13 the call will be worth 20¢ while the puts will go out worthless. Each put and each call has $5.70 worth of time value. On March 13 judgement day arrives and the time value no longer exists. Either the call or the put needs to be $11.60 in-the-money for the position to break even (see chart).
Let’s break down the component parts of the long straddle. The breakeven point for the calls is $215.90. You add the premium of $5.90 to the strike price of 210 to get to $215.90. If you buy 20 of the calls your maximum loss for the trade is $11,800 when FB closes at $210 or lower at the expiration date. This is a strictly bullish trade. The breakeven point for the puts is $204.30. You subtract the premium of $5.70 from the strike price of 210 to get to the $204.30. If you buy 20of the puts your maximum loss for the trade is $11,400 when FB closes at $210 or higher at the expiration date. This is a strictly bearish trade (see chart).
When you combine the long calls position with the long puts position you now can make money in either a bullish or bearish environment. You have also doubled your risk. The downside breakeven point is $198.40. You subtract the combined premium of $11.60 from the strike price of 210 to get to the $198.40. The upside breakeven point is $221.60. You add the combined premium of $11.60 to the strike price of 210 to get to the $221.60. If you buy 20 straddles your maximum loss is $23,200 with FB at $210 at expiration. This is neither bullish nor bearish, but it is heavily biased towards more volatility in either direction (see chart).
That is the story in a static world. We all know, however, that trading is a dynamic world. Let’s look at the “Greeks” in this trade. Delta is the Greek that most traders are familiar with. The FB calls have a delta of 51 and the puts have a delta of -49. Call deltas are always positive since they become long stock when exercised. Put deltas are always negative since they become short stock when exercised.
A 51 delta means that there is a 51% chance that FB will be above $210 at expiration. Since calls are potentially worth 100 long shares at expiration and there is a 51% chance of exercise, the current equivalent share position is long 51 shares 20 times. Since puts are potentially worth 100 short shares at expiration and there is a 49% chance of exercise, the current equivalent share position is short 49 shares 20 times. The net equivalent share position is long 40 shares or positive 40 deltas.
The next Greek to look at is gamma, which is a derivative of delta. Gamma measure the change in delta with a one point move in the stock. If the gamma is 3 for both the put and call and the stock moves up one point the call delta moves up to 54 and the put delta declines to 46. If the stock declines one point the call delta would decline to 48 and the put delta would increase to 52. Let’s say that FB moves up 1 ½ points; the composite deltas are positive 40 and the composite gamma is positive 120. A 1 ½ point move to the upside would result in a position of 220 positive deltas ((1.50x120) + 40) = 220. To remain delta neutral, you could sell 220 shares of stock. If the stock retraces back 1 ½ points you buy back the 200 shares for a $300 profit. If FB declines 1 ½ points you could but 200 shares and if it moved back up 1 ½ shares you could sell out your 200 long shares for a $300 profit. Your maximum loss has now been reduced by $600 by a range in the stock of three points.
You can see that the greater the range in the stock the better it is for you. If the stock just sits there, you have no scalping opportunities and the daily decay in the options will eat you up. If there are enough days with wide trading ranges then you can profit from this position even if FB hits neither the upside or downside breakeven points. This is called delta hedging or gamma scalping. The most important aspect of any trade is not the wisdom of the original position but the mastery of the adjustments that you make to that position.
Note: The values discussed here were calculated following Friday’s close and the massive overnight news on Sunday. The move would be beneficial for this trade.
Dan Keegan, founder of optionthinker.com, operates a six-month one-on-one mentoring program, which brings expertise to new options traders. You can reach Dan at dan@optionthinker.com
