The Hardest Option Trades Are the Best

03/30/2012 7:00 am EST

Focus: OPTIONS

There are no “sure things,” and option profits come only to those who work hard for them, writes Tyler Craig, profiling a very difficult but rewarding straddle set-up in Amazon.com (AMZN).

Recent action in Amazon, Inc. (AMZN) provides a prime example of the risk-reward payoff for the notoriously difficult long straddle play. In an attempt to attract others to their ranks, straddle acolytes possess a number of seductive, yet slightly misleading, tag lines. Take the following for instance:

“You win whether the stock moves up or down!”

The trouble with the assertion is that it oversimplifies how the strategy accumulates profits. Such a mischaracterization leads the well-intentioned masses into thinking the straddle sits close to a sure thing, when in reality, it resides in a different hemisphere altogether.

To those otherwise unfamiliar with the main character in our tale, the straddle consists of simultaneously purchasing an at-the-money call and an at-the-money put that expire in the same expiration month. The position is considered a bi-directional, long-volatility bet.

Contrary to popular belief, it does not win whether the stock moves up or down. Rather, it wins if the stock moves up or down more than is expected.

Sadly, the options market isn’t run by dimwitted ignoramuses. It’s an efficient monster with a voracious appetite for any free lunches that might be lying around. With regards to straddles, this means they will often be accurately priced, making their purchase anything but a slam dunk.

Purchasing a straddle, then, isn’t so much a bet that the stock is going to rise or fall a large amount, but rather that the stock is going to rise or fall more than the options are already pricing in. It’s the expression of an opinion that the marketplace has it wrong. Unfortunately, consistently identifying the mispricing of straddles is easier said than done. The difficulty of such a task explains in part why long straddles aren’t as frequently used as other strategies such as vertical spreads.

In the end, they should be used sparingly in the somewhat rare situations where the efficiency monster has left a free lunch or two lying around. While there aren’t any guarantees, your straddle success can be increased by looking for scenarios where implied volatility is cheap and the underlying stock appears poised for a strong move.

The recent symmetrical triangle in AMZN coupled with its multi-year low in implied volatility represented the ideal scenario for straddle buys. Its breakout and subsequent pop in implied volatility has shown the potential reward available to those prescient enough to jump in just prior to the breakout.

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By Tyler Craig of TylersTrading.com

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