When the Straddle Isn’t Working—Liquidate or Defend?

Once we’re in a straddle trade, our position doesn’t require any immediate management. Essentially, we’re waiting around for the underlying market to move somewhere, or for option IVs to increase, preferably both. About the only thing we need to do is to set a loss point, but the process by which we set this point is noticeably different than when trading pure assets, or when writing options.

When we enter these kinds of trades, if the trade goes wrong (in the case of asset trading) or if it moves considerably against us quickly (the first week, say, in the case of an option write), we’ll exit the trade at our previously decided loss point. This is mostly a one-dimensional decision process and our only usual concern is dollar loss.When buying straddles, setting a dollar or percentage loss point isn’t sufficient.

Deciding on a loss point in this strategy is at least a two-dimensional problem and therefore trickier. Our concern is not entirely the gross amount of loss, as previously discussed, but also at what point in the trade we reach this level of loss. The great thing about buying straddles is that it’s almost impossible to lose a lot of capital quickly, assuming only that we were disciplined in our original selection methods and trade only according to the criteria above (or

other criteria that you may discover and find useful). If our straddle’s underlying market goes dead in the water for roughly the first third of the straddle’s life, we will surely be looking at an open loss, and we’ll be facing our usual question: stay in the trade or accept the loss?The first thing to do at such a pass is to re-examine the current conditions in our straddle’s market. Has the market simply reached equilibrium?

Equilibrium occurs at various times in any market, and is obviously a rotten development for straddle buyers when it does. Can we obtain an indication of market equilibrium? Maybe, and I’ll warn you right now that the method I use is suspect. It’s usually helpful, but can be laughably wrong at times.Assume our straddle is at or very near our pre-decided loss point with twothirds of the trade’s life still to go.

If the trading volume in our chosen market has been pretty steady and the open interest, the number of contracts outstanding, has also been steady or declined moderately, the market is likely at or near equilibrium. In such a case, we probably should exit our trade,because we have exactly no way of knowing how long this unfortunately balanced market may persist, and each week it does persist will remove dollars from our pocket.

In contrast, if trading volume or open interest, or better still both, are rising (keep in mind, we’re only at the one-third mark of the straddle’s life) over this period, we should hold our straddle a while longer. Why? Traders expect
markets to move, correct? If new traders are entering the market now, which is the case if open interest is rising, they doubtless have this expectation, presumably for some good reason, and we should wait around a bit to give them a chance to put dollars into (or in this case, back into) our pocket.

Elapsed Time Changes Our Decision Process:This decision process, stay or exit, changes once the trade reaches the only-10-weeks-left mark. Now, ten weeks is usually adequate time for a market to move far enough to make our straddle profitable, but the knife’s edge begins to approach our throat past this point, and the knife is being wielded by Sister Theta, who is completely merciless.

The theta figure for our straddle at this point is typically somewhere between 0.7 and 1.5%, meaning that we can expect to lose about 1% per trading day of the time premium remaining.Worse, theta will begin rising slowly any time now, and the decay of time premium will accelerate. The only counters for the damage theta will wreak on our capital from this point onward are significant market movement, or a rise in the options’ IVs, or both. If the options’

IVs are still well to the bottom of their 6-month range at this point in the trade, we should consider it unlikely that we will get any assistance here. If the past month’s gross movement is atypically low when compared to our original historical study, we’ve got still more trouble.We’re definitely in the trickbag if both these conditions are true at this point.

If both these conditions obtain, we exit, and right now—no crossing our fingers and rubbing our lucky rabbit’s foot and staying around. If just one of these undesirable conditions is present, and we can see no potential marketmoving event (a government report or possible weather scare, for instance) on the immediate horizon, we’ll exit the trade and accept the loss right away, unless one other set of conditions happens to apply.