This video tutorial is a neutral options strategy in the long straddle. Let’s get right into it here. The market outlook for this strategy is just really looking for a big move in either direction.
If you’re going to trade a long straddle, you want a huge, huge move; you just don’t care which direction it’s in. This is the ideal market neutral strategy. The stock can go up; it can go down.
As long as it just moves and doesn't stay right where it is, then this is a great strategy for you. This is specifically designed for high volatility conditions where stocks are swinging wildly back and forth.
Now, how to set this up is very easy. Think about it like purchasing two long options and just throwing those two options together. All you’re going to do is simply buy a call option and a put option with the same strike price for the same expiration period.
In our example, we’re going to buy one at the money call at 40 strikes, and we’re going to buy one at the money put at a 40 strike as well, so that same strike price. And that's where the option payoff diagram pivots here, right at 40.
We’re going to buy an option here and buy an option there. Now, you can slide these purchases up or down, but most strategies are centered around at the money options because we don't care which direction it goes as long as it moves.
There's no real point in sliding it up here to 50; then you’d be more tilted towards the bearish side. You could slide it down to 30, but you’d be more tilted towards the bearish side on 30 and towards the bullish side on 50.
What’s the risk here? Well, the maximum loss occurs if the underlying stock remains right where it is at expiation, so right at the strike prices. The maximum risk would occur if the stock closes and doesn't move anywhere, just closes right at 40 in our example.
In this case, we’d hit the lowest point on our payoff diagram here, and that would be our maximum loss. In this case, it would be $400. If at expiration, the stock’s price is between the strikes, then both options expire worthlessly, so you lose the money that you outlaid to purchase the strategy.
The profit potential for this strategy is of course, unlimited. The stock could go up as far as it wants, it could go down as far as it wants, capped at zero of course, but the net profit is the gross profit less the premium that you paid.
As always, if you have a strategy where you outlay about $400 which is your max loss, you have to at least make more than that in the value of the options before expiration before you can start to make money.
But really, the profit potential for this strategy is virtually unlimited. So long as the stock moves and moves in a very violent fashion, then you are going to make a lot of money.
With volatility, since we want a big move in either direction, an increase in implied volatility would have a very positive impact on this strategy. Now, notice that I would use the word in this particular slide, “increase in volatility.”
A decrease in volatility is going to not help our position. We are trading a strategy where we want a volatile stock, so we want increasing volatility more rapid and wild movement.
Decreasing implied volatility or stock that starts to trade kind of sideways or right at 40 is very bad for this strategy. Again, increasing volatility is really what we want, not decreasing volatility.
Time decay is actually going to have a negative impact on this strategy as well because remember that we’re buying these options, so they have a finite life and it needs to be a “make-it-or-break-it” type of a strategy where the options need to move quickly, or the stock needs to move quickly in the right direction, whether that’s up or down, but it needs to happen fast.
It can't slowly and progressively move towards that area by expiration, or we’re going to start to see the effects of time decay eat away in our profit. Now because this consists of being long two options, every day that passes without a move in the stock's price, actually has double the impact of time decay.
It's not like having one long call option or one long put option when we have just single time decay to worry about. Now, we have time decay to worry about for both options, so it’s kind of double the timetable that we’re working with. It needs to happen much, much quicker.
Breakeven points on these long straddles are real, really easy to see. All you’re going to do for the upper level (because there are two breakeven points on this particular strategy) is you’re going to take the long call strike and add the premium.
All you’re going to do is take the long 40 strike and add the premium, and that creates your breakeven on the upper level. On the lower level, you’re going to take the long put price and subtract the premium that you got.
Again, the lower level, we’re going to take the long strike of the put at 40 and subtract the premium, and that creates our breakeven on the bottom side. There are two breakeven points on this. So long as a stock is moving like we've continued to say in this video, then you're going to make money if you get beyond those breakeven points.
Now, let’s look at an example real quick. If the stock price is trading at say 40, we are going to buy one 40 calls for $200 and buy one 40 put for $200 as well. Now, the net debit on the trade or the net outlay of money is $400 because we had to buy both of these options.
The maximum loss we can incur is $400. Again, that’s if the stock closes right at our strike prices. And you can see it visually here on the chart that's our max loss at $400. Now, the maximum profit potential is unlimited because these arrows go up.
The stock price can go up as high as it wants to go. There’s no range bound to the high side. The low side, its only range bound to zero, in which case, you’d still make a really good profit.
Some tips and tricks that I've learned along the way when trading these particular strategies: On the outset, this looks like an easy winner, a home run even all the time. You’re probably watching this video going, “Wow! This is an easy strategy. Why don’t more people do it?”
Well, you want to use these during periods of low to high volatility versus adding during periods of already high volatility. Like I said, you want to enter this position when a stock is fairly calm and is predicted to breakout.
You just don't know which direction is going to breakout. It’s not a good idea to add this strategy if a stock is already making a lot of high volatility moves because more than likely, the premiums are going to be so high anyway that any decrease in volatility is going to have a negative impact on your portfolio.
Look to close out the position early if you get a quick move in implied volatility without any underlying movement in the underlying stock.
Like I said before, these are double the timetable, meaning they have to make money twice as fast as a regular option because you’re long two options, so you got twice as much time decay factored in.
If you see a quick move early, don't expect to hold this all the way till expiration. Take the money off the table, take the profit and live to fight another day. As always, I hope you guys enjoyed this video talking about market neutral strategies.
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