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Trading News-Driven Events With Option Straddles

11/09/10 10:08:56 AM
by Billy Williams

Learn to make huge gains with option straddles where you can control risk, even when market direction is uncertain.

Security:   KMX, SPX
Position:   Hold

The Standard & Poor's 500 is screaming higher on increased trading volume right on the end of the midterm election reports, challenging the former 52-week highs. Exploding upward as if lighting a match in a dynamite factory, the S&P 500 went from inert a few weeks ago where the uptrend in place stagnated into a series of back-and-forth trading, resulting in sideways price action to now bursting higher (see Figure 1).

The reason for this is because the markets hate uncertainty and with a looming news-driven event like midterm elections, which is a type of national referendum on the direction of the country and the state of mind of its citizenry, many of the major players in the market tend to hold back from committing fully to one direction or the other. In the past year, the market bottomed early in February to March 2010, only to come back strong through most of the year, leaving volatility relatively light. However, in recent weeks, the market as a whole has become rather contracted.

FIGURE 1: S&P 500. Before the midterm elections, the market just meandered in a tight range, waiting in anticipation of the results. An option straddle at this point would let you profit regardless of which way the market resumed trading.
Graphic provided by:
That ended on November 4, 2010, as the rest of the market digested the election results but also what the agenda would likely be as the opposition took office. Whereas the day after Election Day, trading was lackluster, the opposition party announced that job growth, economic growth, and cutting spending would be its focus and offered its comments without hinting at compromise. Evidently, this provided the type of certainty that the market felt it could take a position on, eliminating the wall of worry that it had to climb up to this point.

These huge events, whether Fed announcements or earning reports, are an invaluable source of opportunities for the intelligent speculator and specifically for the trader who knows how to make good use of using derivatives, better known as options.

Options are a type of derivative that derive their value from the underlying instrument that they are traded on such as a major index like the S&P 500 or an individual stock itself. The greatest benefit of using options are that they are limited in risk to just the premium, or cost, of the option while also controlling a large position of the underlying security. See Figure 2.

FIGURE 2: KMX. KMX traded in a tight box where price direction was unknown. Using an option straddle at this point would allow the trader to profit in either direction
Graphic provided by:
The hardest factor that must be considered when trading options are the limited time value of the option. Options have a limited shelf life in that they are only viable for a given length of time (that is, 30 days, 60 days, one year, and so forth), depending on the time value offered.

That said, trading huge events such as election results or whether the FDA will give approval for a new drug to a drug company will likely result in huge swings in a stock's value that can be maximized by combining different types of options into spread positions in order to capitalize on a given scenario such as news-driven events.

To profit in the market from these types of events, the option straddle is an effective strategy to utilize without being committed to either direction while controlling risk. Option straddles are formed by purchasing both call options and put options at the same strike price and expiration date. The risk is limited to the cost of either option, but the profit potential is theoretically unlimited as the underlying security's price expands, compensating you for the cost of the hedge and pushing the value of the position into profitable territory once the hedge's cost is made.

Identify strong inflection points in the underlying security's price action where the direction from that point is uncertain but is likely to explode in one way or the other. Then set up an option straddle position at that point in order to take advantage of the explosive price action. Using the strategy in this manner will help you manage your risk even while having a nondirectional market outlook but still exploiting massive price swings for profits.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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