A careful selection process for buying straddles, as with almost every other trading strategy we might employ, must include an examination of the history of the straddle over its entire term in some number of years. Just as for the non-seasonal strategy, if the market we’re straddling has not moved around satisfactorily during our intended trading term, historically, for whatever reason and no matter how otherwise attractive it may appear, let’s give it a miss.
Let’s find something else to trade, because any statistical advantage we may believe we have to this point is too possibly only a mirage. We may or may not understand all the factors involved in this market’s poor historical performance in this portion of the year, but, frankly my dear, I don’t give a damn . . . and neither should you.A study of only the historical price movement of the underlying market over the life of our intended straddle is a slightly inferior tool, but it does seem to be sufficient to the task.
As mentioned, I haven’t yet acquired an historical options price database, which would be very nearly the definitive tool for backtesting a straddle-buying strategy, and yet I’ve been quite profitable in buying straddles according to the preconditions described previously.Simple good luck? Possibly, and I wouldn’t discount it. I’d love to have the remaining piece of the analytical puzzle for this strategy, but I can hardly complain, for these entry conditions seem to work both well and consistently.
A Selection Analysis—November 2002 Orange Juice While looking over the markets as I do a couple of times a week, in late April of 2002 I happened to notice that the IVs on the November orange juice (ticker symbol JOX, or OJX sometimes) ATM options were at the dead bottom of their 6-month range. Nothing necessarily indicative about this—OJ can be a very slow market in the spring—but I took a further look.
Was it time to buy straddles on JOX? You decide—Table 8.3 provides the relevant data for JOX and its options on the first day of May, 2002 (which by the way is the date I’m writing this).How say you, ladies and gentlemen of the jury? Do we have the advantage we desire in this market? Shall we lighten the other traders’ wallets?This trade looks to be historically very advantageous to us.
Never a year in the last 12 with less than a 12-cent move one direction or the other in the price of JOX from now until its options expire. The straddle costs us, allegedly,only 710 points, 7.10 cents (but we should always add a minimum of 40–75 points to compensate for general mopery and dopery on straddles in the thin OJ options, trust me on this). The IVs are kissing the bottom of their 6-month range, and that’s favorable, too.
We even get a hefty chunk of hurricane season into the term of the trade. Hurricanes, though they rarely harm the Florida OJ crop significantly, can get the bulls’ juices flowing, and there have been numerous dandy hurricane-scare rallies over the years. Grab it! These conditions are nearly perfect for this approach to straddle buying. The term of the trade is sufficiently long, about 51⁄2 months, and virtually everything is on our side.
The 90-strike options are tradable, but they are thin markets even though 90 is the ATM strike, which implies that we’ll have to pay to play, maybe as much as 30–60 points over the midpoint of the bid-ask spread. On a steady or higher opening tomorrow, I’ll be bidding for the November 90 straddle, without a doubt.What’s our expectation in this trade? What kind of risk to reward ratio can we putatively establish, assuming we can purchase the straddle for 760 points, 50 more than tonight’s settlement price?
Historically, we can reasonably expect to make 4 to 6 cents, less all contest risk, call it $650–$750 net,a perfectly acceptable ROC on our initial cost of $1,170, commissions included. The ROC with this level of profit over the whole term of the trade is 59.8% or 10.9% monthly, but practically never will we stay in this trade until the October 18 option expiration.
It’s probable that we’ll exit sometime in August or September, and the simple monthly ROC if we exit on September 1 is 14.9%. The compounded monthly return (which many traders prefer to use, your humble servant included) is 12.4%. Either figure should be highly acceptable to any but the most, uh, optimistic traders. What’s our probability of success?
As in one of the examples in Chapter 6, the undesirable outcome has never occurred throughout the term of our historical study (and only once going all the way back to 1980), so we’ll use an arbitrary 0.10 failure rate, implying 0.90 probability of success. Our positive dollar expectation is, therefore, roughly $700 times 0.90, or $630 per straddle. Interestingly, we could theoretically risk every penny of our initial capital and still be net profitable in the long term.