12-14 Advanced Lab Notes

Discussion Notes
12/14/09
w/ Tim Justice

First and foremost the discussion started tonight will be a 2 week discussion so the notes below are the start and next week we will finish them.

12/14

Tonight we decided to do something a little different. Rather than review trades and/or look at specific strategies for me to teach to you. I decided to have an exercise with the class where we built a trading strategy with rules and guidelines based on the Long Straddle Model. Any model can be a profitable model. To make a strategy profitable for you and in the current market conditions you have to identify why it will work, how it can work and how you're going to implement it.

Long Straddle/Strangle

~ Philosophy

The speed of the stock is not an important measure. You can use fast moving stocks and slow moving stocks as long as the implied volatiltiy is going to build. Long straddles will be successful when IV builds and/or when the stock moves faster than what the market was anticipating.

You can search for candidates for this strategy based on the earnings cycle. Companies that have earnings 3 to 6 weeks out are more likely to have an IV build. This can be a starting point for your research. Get a list of stocks and then work through them 1 at a time. A perfect candidate is one that has low IV relative to where you think it will be in the future.

Greeks

Delta = Initially constructed as delta neutral. This means that the put you buy and the call you buy are relatively the same delta. This a bi-directional trade. That means it can go either direction you want it to but as it moves the total delta also changes.

Gamma = Because you're long options you're positive gamma. If you buy short term options gamma and delta are bigger components in the trade whereas if you buy longer term options Vega is a bigger component in the trade.

Vega = Because you're buying calls and buying puts you are positive vega. You want IV to build on this trade.

Theta = Because you are buying calls and buying puts you are double negative theta. You need an IV build and or a move in the stock that wasn't anticipated by the markets pricing of options to overcome time decay.

~ Construction

What strikes to use (based on delta), what expiration months to target, how much capital you're going to use in your account.

Delta = Your net delta per contract must be =< .05 ~ .10. For example if the put delta is -.60 and the call delta is +.45 then you have have a -.15 total delta. This would be too bearish to implement. If the put delta was -.52 and the call delta was +.48 then you only have a -.04 net delta. This would fit the guideline.