Hey everyone.
This is Kirk, here again at optionalpha.com where we show you how to make smarter trades.
In today's video tutorial, we’re going to talk about making adjustments to a short straddle
option strategy.
Now because these short straddles have the same at the money put and call strike, it's
much harder to adjust these positions because they’re already so close together and entering
these trades will usually give you a very large credit which will naturally just make
your breakeven points wide to begin with and therefore, room to wait it out during the
extended runs in the stock.
However, let's assume you sold a short straddle directly over where the stock is trading and
took in a huge credit, somewhere around $10.
We’ll go over a live example of this later on in this video using SPY.
We would look to adjust this trade if the stock rallies significantly beyond our breakeven
points and there is a lot of time left until expiration.
The key here with the short straddle is that we don't have really predefined adjustment
points like we do on a strangle.
On a strangle trade, we might adjust if one side is reaching a 30 Delta or a 40 Delta.
In this case with a short straddle, because your option strikes are so close together
already, basically at the same at the money strikes, there's no way to tell which way
to adjust.
We just have to let the market move.
If it does move significantly beyond our breakeven points, at that time, what we’ll do is roll
one side of the trade closer to the market.
Very similar mechanics to a short strangle, but with a straddle, there's no really set
in stone area.
What we look for is breakeven points being violated and there’s got to be a lot of
time left in expiration.
If our breakeven points are violated, but there’s only three days left or five days
left in expiration, then we might let the trade run till expiration.
But if it's violated very quickly and we still have 30 days to go or 40 days to go, then
we definitely will make an adjustment a lot quicker.
Just use a little bit of commonsense as you go through that.
Here's what we would do.
Let’s say that we enter our trade and the market starts running higher towards the call
side of the trade.
What we would end up doing is rolling up the put side closer to the stock price and take
in an additional credit.
At this point, you’ll have gone inverted.
Now with both options in the money, you’ll have a put option that is higher than your
strike of your call option.
That's why you go inverted.
With both options that are technically in the money, your target is to buyback the spread
for the width of the inverted strikes.
You can’t buy it back for zero.
It won’t go to zero.
Once you’re inverted, the most you can make is whatever values they are down to the width
of the strikes.
That’s a big question we get.
With the inverted spreads, you can’t just let the options expire worthless.
One of them is going to be in the money or both of them are going to be in the money
at the same time.
Here’s what we’re going to do.
We’re going to go over an example right here on our broker platform in Thinkorswim.
This is live trading right now and you can see SPY is trading right about 205.
It actually works out pretty good.
In this case, what we’re going to do is do the March 205 straddle which is right over
the market.
You can see the 205 straddle right over the market, it's the options that are right at
the money and that currently is giving us about a $975 credit, so a pretty good credit
for that type of a trade.
When we go to the risk profile here, we can see that that looks very similar to what we
typically suggest a straddle looks like.
It's got that high peak right over where the market is trading at 205 and then from there,
it goes down on either end, undefined risk on either end.
But now that we took in that big credit of $975, that helps move our breakeven point
out $9.75 on either end.
You can see even though our strikes are right over the market, our breakeven points are
very wide in this situation, so it naturally gives us wide breakeven points that are far
out of the money and this is why straddles work so good.
When implied volatility is high, you can take in a lot of credit.
Now, let’s say that the market which is currently trading at 205 trades all the way
up and starts to violate our call strike on the topside, so now the market is trading
up here and now it’s absolutely violated the breakeven point on our call side.
Now at this point, we might look to make an adjustment where we roll up the put side of
the trade closer to the market.
As the market has been rallying higher, this put strike that we’ve sold, the 205 is starting
to lose value and starting to gain a profit just on that side of the trade.
What we want to do is we want to bank that profit, close that trade out and roll or reestablish
a new position at a more current strike price, so we might roll up to say the 210 strike
price.
We would go from 205 and roll up to the 210, take in more credit because this 210 put option
is going to be worth more money since it’s closer to where the stock is currently trading.
One of the ways that we can do this just like with a strangle is we can trade this with
a vertical spread.
We would do something like selling the 210 and buying the 205 option.
I’ll just create that here.
You’re not going to get $240, but maybe you get another $100 or so because we don't
know when the market is going to move.
But you can see we’re basically using a vertical credit spread to facilitate this
roll and we’re basically selling out the 210s and we’re buying back the 205s that
we're already short.
The net difference in that is whatever credit you’re going to take in.
In this case, we’re going to take in an extra dollar of credit.
Now that we’ve made this trade, you can see now we have a position that looks like
this.
Now it's inverted, it’s got more of a flat top which is the width between the different
strike prices now.
That's the flat top area, that’s the width and the length of the two different strike
prices, the 205 calls and the 210 puts.
Remember, we’re inverted now because the put options are up here at 210 and the call
options are here at 205.
The most we’d be looking to close out this new position at, this new trade is we’d
be looking to buy this back for at least or the very least we can buy it back it for is
$5 which is the difference between the strike prices.
But as have rolled the trade higher, you can see that we’re starting to move this breakeven
point much, much closer to where the stock is currently trading.
By doing that and rolling it closer and going inverted, we definitely bank a profit on the
put that we’ve sold that has now started to make money.
That side is closed out.
We reestablish it with a new credit.
That new credit helps move the breakeven point out even further.
You can see if we rolled it even closer, let’s say we rolled it all the way to 215, so we'll
keep that at 205, we’ll move this up to 215 and let’s say that instead of a $1 credit,
we took in a $200 extra credit.
Now you can see that $200 extra credit that we took in here helped move the breakeven
point out even further to a level that's beyond where the stock is trading right now.
That's the benefit of doing this type of adjustment, is we take in a credit, we definitely acknowledge
the fact that the stock moved, but we also try to widen that breakeven point out as much
as we can to compensate for the stock now moving here.
At this point, we’re just hoping that the stock is going to maybe make a move back down
because it moved so far so fast up that we want to see the stock move back down or implied
volatility move back down in the meantime.
Here’s the thing with short straddle adjustments.
It's important not to get too carried away with aggressive adjustments.
Even though we talked about taking in a big credit, you have to remember that going inverted
is not necessarily the best thing.
Rather, you should focus on entering these trades at a much higher level of implied volatility.
These are the ultimate strategy to take advantage of super, super high implied volatility markets.
You're not going to enter these, definitely not enter these during low implied volatility
markets, but you really want to enter these very few times throughout the year when implied
volatility is very, very high in the 80th or higher percentile.
At this point, if you enter them in the right way and the right market, you’ll have an
opportunity probably to manage your profits much quicker as implied volatility drops.
Remember, with these short straddles, we’re not looking to gain all of the credit.
We’re not looking to let it go all the way till expiration.
We like to close out these trades early when we’ve reached a certain percentage of our
max profit.
You can download one of our strategy guides inside of our membership area at optionalpha.com
which helps with adjustments not only to this trade, but also we have guides in there that
help with how to manage trades and when to close them out.
You can get those all at optionalpha.com.
I hope you guys really enjoy these videos.
As always, if you have any comments or questions, please add them right below in the lesson
page.
Until next time, happy trading!