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Wednesday, February 07, 2007

2 Tales Of Straddle

Buying straddles is a volatility strategy which is discussed in both "Profits with Options"-by Lawrence McMillan and "Options Made Easy"-by Guy Cohen.

For myself, straddles are not my bread and butter type plays, I buy straddles occasionally during the earnings season if good opportunities arise. I usually buy ATM, current month or at most next month out as straddles are not cheap, having to buy both the call and put legs. So far, this strategy has been doing ok, with some winners and some losers. Losses are so far within my pre-calculated worst case scenario, but in my opinion, I think the straddle strategy can do better, so I'm looking to fine-tune it in the coming months.

There are similarities and differences in McMillan's and Cohen's strategies. Let's take a quick look here:

Similarities
1.At least 3 months to expiration

2.Exit no later than 1 month to expiration left

3.Look for underpriced options by comparing IV with HV and average IV (though both have a slightly different approach to comparing volatility)

Differences
1.Straddles for earnings announcement or NOT?

->McMillan does not recommend buying straddles ahead of earnings as his study shows this strategy will lose money as traders could be overly optimistic about volatility that earnings announcement might cause

->Cohen's ideal entry for earnings play is 1-2 weeks before earnings announcement

2.Timing of Straddle Purchase

->McMillan's style is to buy straddle on the day before the decision (e.g. FDA, lawsuit etc) is made public

->For Cohen, it's as above: 1-2 weeks before event

3. Probability Calculation

->McMillan wants at least 80% chance the stock will EVER hit one or the other breakeven points at any time prior to expiration.

->No mention by Cohen on this

So what do you think of the above approach by McMillan and Cohen? How's your experience so far with straddles? Don't be shy to share them here.


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