I have been paper trading high volatility straddles near or at the money. Is this stupid? My account has been pretty healthy. I even bought an ADM may 07 40 strattle on todays earnings call.
Well, the orthodox view is that you buy the straddle during low volatility times when the options are relatively cheap. Why? Because if you buy when the IV is high and the news breaks, you lose money because the IV collapses on both the calls and puts you bought. This can overwhelm the profit from any directional move. You're probably not putting the odds in your favor as much as you could even though you may have been making some money.
Just remember this. If a stock is $30 and you pay $4 for the straddle, the stock has to move MORE THEN 13% for you to BREAK EVEN. The wrong leg of the straddle will be almost worthless after the IV implodes, and the right leg of it will be trading at near intristic value. I can't tell you how many times I've lost on both sides of a straddle or strangle.
What if I enter lower volatility straddles, still near or at the money and I give myself a longer timespan. Instead of buying may, I'll buy June or July. I know I will have to pay a higher premium for that. But will it increase the chances of a volatility increase? Maybe I should just stick to the basics of Near in the money calls with stocks with strong up trends as I was doing before.
Buying further-out options makes more sense due to theta (time value decay). For near-month options, theta is higest. For a straddle you're buying far enough in advance of an anticipated big move so that IV isn't too high. Yet you don't want theta to eat you up while waiting for the "big event". It's a balancing act for sure.
the easiest to breakeven straddles on are probably about 1 week from expiry. But you better get your move.
I agree, if you're pretty sure about a big move. What I described is more conservative. YHOO seems to be one of these stocks that have nice big moves nearly every earnings announcement.
Thanks alot guys! Options certainly impress me everyday with its complexities. I hope someone here had a straddle on DJ! If you live near Chicago I would like a ride on your ferrari