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Q & A. Weekly’s Put Spreads and Straddles

Two ideas from a reader.

Mark,
I think vertical spreads (bullish put spreads )would be the way to go. Especially on the Weeklys. Find a stock or etf that barley moves, and make sure u sell the profitable side before expiration, and let the loosing side expire… It’s a no brainer for streaming income…

OR buy straddles or strangles during earning season, and only buy highly volatile stocks…same as above.. Close out the winning side and let the other expire worthless.. Better chance using these strategies to make $ than many other strategies .

Bill

Hi Bill,

I agree that vertical credit spreads represent an excellent opportunity to make money with limited risk — as long as position size is appropriate.

However, reality is not quite as simple as you describe it. For one thing, it is difficult for the inexperienced trader to earn income as a straddle buyer.

Vertical spreads

  • Weeklys options tend to be low priced, and that makes the available premium small.
  • If you use stocks or ETFs that “barely move” then the option premium will reflect the non-volatility of these stocks. Translation: very small premium with very little profit potential. We each have out own idea of how much credit to accept for a 5- or 10-point spread, but I do not like the idea of accepting only $0.05 or $0.10, even though the odds of having a winning trade are high.
  • “Close out the winning side” and allow the other to expire worthless is not viable, in my opinion.
    1. When selling credit spreads, the usual practice is to sell OTM options — with the hope that all options will expire worthless. Thus, there is seldom a “winning side.” And when there is, the other side will not be too far out of the money and carrying it naked short is far too risky.
    2. Selling one side leaves the trader with a naked short position. Although a reasonable strategy for the experienced trader, I strongly discourage newer traders from owning naked short positions. When the option is a call, most brokers will not allow their customers to own such positions because (in theory) the potential loss is unlimited.
    3. I like the idea of no-brainer strategies as much as anyone, but in the trading world, these strategies rarely occur and most fall under the umbrella of “arbitrage.” For me, this plan has a small possibility of causing a giant loss (after selling your long option), and that takes it out of the no-brainer category.
  • When trading Weeklys, instead of adopting your suggested approach, I’d prefer selling the options naked in the first place, rather than buy the spread and then sell the long option 2-3 days later. I’m not recommending this plan, but if position size is small, it should work better – especially when the premium for a spread is so little.

Straddles

Buying straddles in earnings season is a high-risk play. It can work, and one advisor whom I know has done very nicely with this strategy. But it is mandatory to do your homework. The timing of the purchase (never at the close of trading when earnings will be announced prior to the next day’s opening) matters. Some stocks lend themselves to the straddle play better than others. Again do your homework.

It is very acceptable to sell the winning side, but in my opinion, that sale should be made sometime near the opening of trading. NEVER enter a market order; and especially not at the opening. Always use limit orders. You bought an option at high volatility and you cannot afford to hold and allow residual time value to decay. Do not turn this into an investment.

Yes, you can allow the non-winning portion of the strangle to expire worthless, but I believe that it is far better to sell it at the same time that you sell the winning portion of the trade. Of course, I would not sell for as little as $0.05 or $0.10 (because miracles do happen), but $0.50 is real money when trading straddles and you cannot simply allow that cash to get away.

One more point: When the earnings news is right on target, your straddle will lose a lot of value. Accept that and dump the position before IV collapses even more than it did at the opening of trading.

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Selling Strangles Prior to Earnings

Hi Mark,

What is your opinion on a short strangle vs a short straddle?

I understand the same unlimited risk will be there because you are trading naked options. I found that one strategy I have had some success with in paper trading is using short strangles around earnings to take advantage of large drops in volatility. I was taught that one of the assumptions used in this strategy is that for the most part, the market has all ready priced the option correctly for the upcoming news so by allowing for some price movement within your strangle, this is more of a volatility play than a price play.

Steve B

***

Hi Steve B,

1) To me they are the same, with the straddle being a subset of the strangle  In other words, a straddle is merely a strangle when the strikes and expiration dates are the same.

I prefer the strangle because it allows the trader to choose call and put strike prices independently, rather than being 'forced' to choose the same strike.  I prefer to sell OTM calls and puts – and that's not possible with a straddle.

As far as unlimited risk is concerned, that's a decision for each trader.  I prefer the smaller reward and increased safety of selling credit spreads (an iron condor position), but that is not relevant to today's post.

2) A clarification.  In is not 'volatility' that incurs a large decrease after the news is released.  Instead it is the implied volatility of the options.  I'm fairly certain that is what you meant to say.

3) Your earnings plays are far riskier than you currently believe them to be. These are not horrible trades, but neither are they as simple as you make them out to be.

4) I must disagree with whomever it was who told you that "the market has priced the option correctly for the upcoming news."  The market has made an estimate of how much the stock price is likely to move.  Note that this move may be either higher or lower ad that this difference is ignored when the size of the move is estimated.

There is no formal prediction of move size.  There is nothing that says the stock will move 6.35 points.  What happens is the implied volatility rises as longs as more and more buyers send orders to purchase options.  And it makes no difference if they are calls or puts [See last year's post: puts are calls; calls are puts].  At some point option prices stabilize (or the market closes for the day) and a 'final' implied volatility can be measured. 

From the IV, the 'anticipated move' for the underlying is determined.  AsI said, it's not as is everyone agreed on how much the stock will move.

I hope you understand that when the news is released, there is very little chance that the predicted move is the correct move.  Many times the move is far less than expected.  That's the reason why selling options prior to earnings can be very profitable.  The IV collapses because another substantial price change is NOT expected and there is no reason to pay a high IV to buy either calls or puts.

However, if you chose to sell an option that was not very far out of the money (OTM), and if the stock moves far enough, then the IV decrease doesn't do a whole lot of good.  Sure you gain as IV plunges, but you can easily incur a substantial loss when the short option has moved significantly into the money.

Also remember that part of the time thet stock price gaps by far more than expected.  In that scenario, a higher quantity of formerly OTM options are now ITM.  Thus, large losses are not only possible, but they are more frequent that you realize.  Apparently your trades have worked out well (so far).

Think about this:  If those option buyers did not profit often enough to encourage them to pay 'high' prices for the options they buy, they would have stopped buying them long ago.  The truth is that these option buyers collect often enough to keep them coming back for more. 

5) That means you must be selective in which options you sell into earnings news.  This is especially true when you elect to sell naked options.  You cannot options on every stock, hoping that any random play will work.  This is a high risk/high reward game.  It's okay to participate, but please be aware of what you are doing and the risk involved.

827

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