One positive step we can take is to simplify the game. Why does any trader trade in a market? He expects, sometimes rightly, sometimes wrongly, that the market’s price will move in his favor over some period of time.This expectation is completely reasonable.Why would we trade anything if we did not anticipate some sort of profit from the movement of its price? I certainly wouldn’t, and I somehow don’t think you would either.
Of course, if the market moves in the undesirable direction, our trader is going to lose capital. Now, card-carrying capitalists that we are, we must ask “OK, how can we turn a profit from this information?”The straightfor ward way to profitfrom the simple gross price movement of a market without fretting about its direction is to buy a straddle, a call and a put having the same striking price and expiration date.
The naïve view of a straddle is that it will become profitable when the underlying market moves one direction or the other by more than the total premium we paid for the straddle. The price points (one higher, one lower) at which this occurs are sometimes called points of absolute profitability, but the view itself is incorrect. The underlying market doesn’t have to move anywhere nearly that far before we begin to profit.
For a quick and entirely typical example of this phenomenon, let’s take a look at the CME/IMM Japanese
Yen. On November 8, 2001, I bought a few March 2002 yen straddles with a strike of 84.00 when the March yen contract was trading at 83.90. We’ll look at the rationale behind this purchase shortly, but right now we want to
see how long it took and how far the futures contract moved before the trade became profitable.
It did so more quickly than usual, a lucky outcome,but the amount of price movement March yen underwent was in no way extraordinary. The straddles cost 368 pips apiece, $4,600 plus two commissions, and,courtesy of the bid-ask spread, they settled at 360 pips the day I bought them,contest risk having been present as always. March yen (ticker JYH) edged down 108 pips to 82.82 over the next five trading days . . . by which time the straddle was at 376 pips, a
touch better than breakeven after allowing for commissions paid on the exit side of the trade. In the next two days, for what reason I can’t recall, JYH moved down another 90 pips, to 81.93, and the straddle was now well profitable. I made a note during the day session that the straddle was quoted at 390 bid/415 offered when JYH was trading
at 82.53, so I suppose it’s fair to say that the straddle had moved legitimately into the plus column approximately
when JYH was trading at that point.March yen had moved just 137 pips, 1.63%, in a little less than seven trading days and the straddle had already become profitable? Exactly.Granted, this almost-immediate move doesn’t and certainly won’t always occur (it was a bit of good luck), but that’s not the point. The point here is distinctly that a market in which we buy straddles does not have to move more than a decent fraction of our purchase price for our
straddle to become profitable.Now, sometimes this apparently too-quick profitability occurs because of markedly rising IVs in our market’s options. Not this time; yen’s 6-month IVs were 9.2%, and were just 0.4% off the low point in their recent historical range. The yen option IVs did rise later on in this trade, but when the straddle became profitable, IVs were still sitting at a lowly 9.7%. March yen subsequently went on an extended cruise downriver, and
the trade ended up very nicely in the profit column. That’s all very well, and hurrah for the home team, but the question to answer is “How do we select straddles having a high theoretical probability of success?” Our procedure for making this decision turns out to be a direct and fairly easy one. We’ll decide which markets’ straddles may present an opportunity, then we’ll see if the history and the current volatility of one or another of these markets look as if they’ll cooperate in putting dollars into our pocket.