Long Straddles Allow Investors to Have It Both Ways

The strategy of simultaneously buying calls and puts allows you to bet on a breakout even if you don't know the direction.
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Abe Lincoln

once said that time is nature's way of keeping everything from happening all at once. There are circumstances, however, when we mortals

do

want it all.

We've all, at one time or another, been in a quandary about where a stock was headed. Charts can hint at a potentially substantial move, but rarely give clues as to the direction. Option traders learn early in their careers that long straddles, the simultaneous purchase of calls and puts, allow them to reap the benefit of breakout moves in either direction. Since two option series are purchased, it makes sense to buy the straddle only when options are "cheap." But options aren't cheap simply because they only cost a few pennies per share; they are cheap when their embedded volatilities are low and expected to rise.

American Bankers Insurance

(ABI)

options serve as one illustration of that concept. In 1998, American Bankers' merger plans with consumer services giant

Cendant

(CD)

fell apart, but Dutch-Belgian insurer

Fortis AG

agreed to acquire the company in early March 1999 for about $2.6 billion. While the deal is expected to close in the third quarter, concerns emerged recently when one of American Bankers' London-based reinsurers filed a fraud and racketeering suit against its insurance broker.

Let's assume you figure an 80% probability that fallout from the suit will scotch the merger. That leaves a 20% chance in your mind that the deal closes. Either way, you reason, the dust should settle and the stock should break out of its narrow trading range by mid-July. On the upside, you target 60; on the downside, 40.

Currently, ABI trades at 52 1/2. While the stock was locked between 52 and 53, implied volatility nose-dived to historically low levels. Over the 50 preceding trading days, for example, ABI's historic volatility has been 30%. But in just the last month, volatility has shrunk to 6%. The expected volatility, reflected in the Oct 50 straddle, is now 17% to 18%. Let's suppose you believe market volatility and implied volatility will approach 30% within the next three months. If you're looking to shade the straddle for the higher probability of a downside break, you can create a version known as a

strip

by buying puts in a 4:1 ratio to calls as shown here.

It's easy to see the bearish lean of the strip by looking at the net delta. Delta will not remain constant throughout the life of the strip, though.

Delta shifts with the passage of time and with movements in the price of the underlying stock. Significant movement in the underlying will make the strip either more bullish or more bearish. Here are projections for the theoretical delta values for the strip by mid-July.

Naturally, a flat market is the strip's anathema. And because five options have been purchased, the effect of time decay is greatly magnified. The chart below illustrates the loss potential attributable to time decay if ABI remains at 52 1/2 through mid-July.

The sensitivity of an option position to the passage of time is quantified by a measure known as

theta

. Theta measures time decay in cents per share. It's normally expressed as a negative number for long options to denote the loss of premium due to the passage of time. Not surprisingly, theta is signed positively for short options to reflect the "earning" of time premium by the writer. Thus, the Oct 50 ABI call starts with a seven-day theta of -.074, while the Oct 50 ABI puts' seven-day thetas begin at -.038.

The call therefore can be expected to lose about 7 cents per share in a week, while the puts are projected to shed about 4 cents each. The chart below exhibits that the strip can be expected to lose a total of $22.60 per week in time premium. However, the pace of time decay, like that shown in the chart above,

theta

accelerates as expiration approaches.

Like delta, theta varies as a function of time remaining to expiry. The absolute value of theta is greater for short-term options, especially at-the-money ones, than for longer term options. In a moment, we'll illustrate the aggregate theta for the strip under the same flat market scenario postulated in the chart above. With the exception of the "hiccup" occasioned when ABI trades ex-dividend, the time decay risk measured by theta becomes more pronounced over time.

Option buyers often shop for longer-term positions to mitigate the effect of time decay. For example, even though you projected a breakout move by July, you opted for the further-out October expiration. That decision in part is predicated on the relative value of the later series' additional time premium. Like delta, theta also fluctuates with volatility. Options on highly volatile stocks exhibit the greatest theta values, in terms of absolute value. ABI's recently diminished volatility actually compressed time values. So, another distinct advantage of buying a strip during a period of relative quiet is the deflation of time premium and the resultant flattening in time decay curve.

So, where's all the good news in this? Well, if you're right about a breakout, the strip's returns can be quite handsome. Witness the value of the strip in the chart below if your price (40 or 60) and your volatility (30%) expectations are realized by mid-July.

If both volatility and price expectations are met within the projected time frame, a profit seems virtually assured, given an unflinching belief in the validity of your assumptions. The profit obtainable on the net position may seem rather paltry in a bullish environment when compared with that earned in a falling market. Still, a move to 60 under the higher volatility scenario nets a 30% return, before transaction costs. On a 14% move in the underlying stock, that's nothing to sneeze at if you have cheap transaction costs. And if ABI collapses to 40 by July, that 24% break leverages into a 313% net return.

Profit prospects dim under a lower volatility, flat-to-bullish scenario, however. And ultimately, at expiration, volatility won't matter, since the options will then only be worth their intrinsic value. In that case, the closing bell for a flat market becomes a death knell for any purchased time premium. If ABI remains stuck at 52 1/2 through October, the strip will expire worth only $250, a loss of 74%. Worse still, if ABI gives up a couple of bucks to end up at 50, you'd lose the entire strip premium.

Option buyers should carefully monitor the impact of time upon their positions. At a certain point, the only compensation for the decay in time value is the accrual of intrinsic value. That's when it's best to consider another of Honest Abe's aphorisms: "The best thing about the future is that it comes one day at a time."

Brad Zigler is managing director, options marketing, research & education for the Pacific Exchange in San Francisco. He can be reached at

bzigler@pacificex.com. Options entail risk and are not for everyone. The strategy discussed, including examples using actual securities and price data, is strictly illustrative and educational. It should not be construed as an endorsement, recommendation or solicitation to buy or sell securities.