As part of our ongoing Wealth Daily options educational series, which has included:
- How to Invest in Options
- How to Buy LEAP Options
- Options Intrinsic Value
- ETF Options Trading
- Crisis Investing
- Lockup Expirations
- How to Trade Like a Hedge Fund: Secrets of an Options Trader
…we now delve into more advanced options terminology. And that brings us to a recent reader question:
Ian, I’ve been trading with Options Trading Pit since December 2008 with great success. But I’d like to understand a bit more on options. Can you explain what straddles and strangles refer to?" —Mike A.
The Difference Between Strangles and Straddles
With an options straddle position, you’re simply buying a call and a put on the same stock, with both options having the same expiration date and strike price.
Say for instance, you wanted to straddle Apple (AAPL) with options. You’d buy, for example, the March 2009 100 call and the March 2009 100 put. But you must understand that when trading a straddle, you’re likely to pay a commission charge when opening and closing both positions.
When buying only calls or put, you’re playing a directional strategy. With the straddle however, which includes a put and call, you’re not playing a directional strategy. Traders will use the straddle if they feel a large move is coming, but remain unsure about direction. An example may include an upcoming FDA decision. If the news is encouraging, the underlying security is likely to jump along with the call, while killing off a put premium. If the news is bad, the underlying security is likely to fall, and kill off the call premium, while pumping the put option.
As for the strangle, you’re buying a call and a put on the same stock with both options having the same expiration date. The only difference is the strike price. Let’s use Apple again for our example. To exercise a strangle position, you’d buy, for example, the March 2009 100 put and the March 2009 95 call. But again, to play this you’d have to pay two commissions to open and close the positions.
With a strangle, while I wouldn’t recommend trading earnings announcements, you’d use it to play earnings announcements, for example. If earnings and outlook are positive, you could see a positive impact on the stock. If earnings and outlook are horrendous, the stock could fall rapidly. The risk to a strangle is if the stock price remains stable or falls between the strike price of the call and put option.
And, in a nutshell, those are the basics on strangles and straddles, which we’ll use in Options Trading Pit.
The next question comes from Susan L., who asks:
"What are the benefits of trading LEAP options, as compared to just buying stocks for the long term?"
LEAPS cost only a fraction of owning a stock. And they’ve been known to rocket higher as the underlying price moves. Say you own a $50 stock, and it goes up $5. Your gain is 10%. But say you own the January 50 calls, for example, at $1 and the stock went up $5. You could now be sitting on 400% gains.
That’s how you maximize your potential gains. Not by worrying about time decay, or making scant gains from holding overpriced stocks.
Your risk is known.
You can buy LEAPS calls if you think a stock is rising. You can buy LEAPS puts if you think a stock is heading lower. There’s a lack of time decay.
- You can play "big picture" trends, using commodities such as gold. Say the dollar gets weaker. Investors run to gold as a safe haven, and you own the XAU LEAPS that’ll leverage your gains when gold moves in "your" direction.
You wouldn’t want to buy a lot of options on a play with less than 30 days to expiration, unless you had strong confidence that Stock A will definitely be in the money – or you may be one of those people that really likes to gamble.
Time decay is also typically represented by a Greek term known as Theta, or how fast the option will lose value as it approaches expiration.
Theta and other Options Greeks will help you estimate your risk, and allow you to answer specific questions about an option contract’s expected price moves.
- Delta, or how will the value of my option change and underlying stock price changes? Say for example, the delta for Apple is 0.50. As the underlying stock drops $1, the option will change by 50 cents per dollar. Therefore, if the stock falls by $1 to the upside, for example, the call option will increase by 50 cents, and so on.
There’s also Gamma, Lambda, Rho and Vega, but not wanting to confuse, we’ll get into their usage with individual options trades. They’re easier to learn with practice.
That’s it for now. If you have further questions, please feel free to leave questions in the comment section below.
Oh, and in case you’re a bit skeptical about trading options with us, here’s what a reader had to say recently:
"Ian gets it right far more often than wrong. I read his material regularly and his options track record is one of the best in the business."
Ian L. Cooper
Editor’s Note: It’s no secret the money being made in today’s stress-filled markets are coming at the hands of traders. So, if you knew you could rely on a true trading guru… someone who not only delivers consistent gains over and over, but also who goes out of his way to guide and educate his readers on each and every options trade… would you pass up the opportunity? Truth is, Ian Cooper is the secret weapon thousands of investors use to pad their portfolios. He predicted the collapse of the housing market, and his readers profited. He called the bursting of the U.S. Treasury bubble, and his readers are still profiting. And now, he’s called the undoing of the commercial real estate market. And believe me, his readers are waiting with baited breath on every trade he recommends. If you’re ready to give Ian Cooper and his Options Trading Pit service a run, simply follow this link to learn more. (At this writing, Ian is 39 for 49, with a 58% average gain, and 11-day average hold time.)