12/21 Advanced Lab Notes

Discussion Notes
12/21/09
w/ Tim Justice

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.m

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. When selecting the options to trade you may or may not use the same strike. It's more important that you have the same delta. Look for options that have somewhere between .40 and .60 delta per contract. Whatever the delta is on the call you select make sure that is the same delta on the put that you select or as close as you can get it. When selecting an expiration month, use the 3rd or 4th expiration choice to minimize the theta rate and also maximize a vega based move. Depending on your tolerance for risk and account size use somewhere between 1 and 4% of your account. I recommend 1% but if you're trading in a small account and or want to take a little more risk go ahead and lever up to 4%. Whatever your position sizing rule is you need to be consistent from trade to trade. Don't spend 1% on a trade then the next trade spend 4%.

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. ~ Management Exiting on a Loss. The most important risk control you have is in your capital spent. Keep this number set according to your guidelines on your construction section. If you want to develop a loss based exiting rule then something like half of your total cost would be appropriate. So if you spent 1000 and at some point are down 500 then you are forced to get out. Exiting on time. Based on the above construction you DO NOT want to hold this trade through earnings. If you want a straddle model that you hold through earnings you need to use shorter term options with higher delta's that don't have much extrinsic value built in. Exiting on a Profit. Use a risk graph and factor in time decay up to the event, your IV assumption and a reasonable directional assumption based on the time you'll be in. The direction can be determined by Bollinger Bands, Probability Cones, and/or a simple reading of the chart with ATR in mind. Assignment for 12/28/09 ~ find some stocks that will release earnings in the 2nd half of January. Select a candidate that fits the above philosophy, use our construction guidelines and enter the trade into a virtual account. We'll look at it and discuss as a class on the 28th.