Previously, we have looked at selling premium and why it works. To follow up with this topic, we wanted to take a look at another short premium strategy, a straddle.

In summary, a straddle is formed from the simultaneous sale of an at the money call and an at the money put.

Tom Sosnoff and Tony Battista compare selling a straddle to buying a straddle. They found that 66% of the time selling the straddle worked for a total profit of our $35,000.

Next, the guys wanted to take this one step further and put some context around the expectations of these trades. They found that in 89% of the trades, there was a point before expiration where the trade had a negative profit/loss.

This is important to know so that you stick with the trades and don't close out just because you have a small loss. The guys also find out that on 44% of the trades, they were able to close the trade with 50% of max profit or more.

Finally, Tom and Tony add the element of Implied Volatility (IV) to the mix. They found out that they are able to get an extra 10% edge when looking at high IV. This means that when only selling high IV straddles, they won 76% of the time compared to the 66% of the time if selling mechanically!

Transcription:

Tony: Thomas, we're back my friend. E-Mini the S&P's up 550. Nasdaq up 24. Russel up 250. Dow up 48. VIX staying weak VX down 36 cents. Bonds down 12. Oil down 24 cents.

Tom: Sorry. Give me one more second.

Tony: Not quite how I wrote it up.

Tom: Not quite how you wrote it up?

Tony: No.

Tom: I'm just trying to …

Tony: Twitter down 6 bucks, trading at 259.

Tom: They gave me one lot.

Tony: Working some [baba 00:00:41] calls at 420, there.

Tom: I'm just trying to neutralize. I'm trying to neutralize some of our risk because we have a lot of outlier, just options out there.

Tony: Mm-hmm. (affirmative) In Twitter, you're talking about.

Tom: In Twitter. I think that we've done that. I think that. I think, think, think. Okay. Cool, cool, cool. Sorry.

Tony: Gesundheit.

Tom: Excuse me.

Tony: Mm-hmm. (affirmative).

Tom: All right. Are you ready?

Tony: Twitter at 42.63, down about 6 bucks.

Tom: Yeah, yeah, I think …

Tony: 6 dollar expected move, made small.

Tom: Yeah.

Tony: Stock rallies a buck, you'll make better.

Tom: The bottom line is, you're right.

Tony: Mm-hmm. (affirmative)

Tom: We made small. I think there's one order we have left to do, which gets us out and in that … Let me just cancel replace this and just put this one order in.

Tony: Sure.

Tom: I'm going to buy these puts back and [inaudible 00:01:41] and then we're all done.

Tony: Mm-hmm. (affirmative)

Tom: With all the risk. There you go.

Tony: Yup.

Tom: Risk all done. Now, we will … in most mornings when you have a big …

Tony: You took off the weekly options, right?

Tom: I took off all the weekly options.

Tony: Good.

Tom: Yeah, now our position's relatively flat. We're done.

Tony: Mm-hmm. (affirmative)

Tom: I took off …

Tony: Where did you buy the weekly strangle back at?

Tom: The weekly strangle that we sold yesterday for 225?

Tony: Uh-huh. (affirmative)

Tom: I just paid 130 for the puts and I bought the calls back for 2 cents.

Tony: Got it.

Tom: The weekly strangle that we did on the show, I paid 132 for it and we sold it for 225. The weekly strangle worked out beautiful.

Tony: Yeah, the weekly strangle was probably the big winner of the bunch.

Tom: Yeah. Mm-hmm. (affirmative) The weekly strangle was the big winner of the bunch. Also, the November strangles, they worked out beautiful too.

Tony: Mm-hmm. (affirmative)

Tom: The November strangles worked out and the weekly strangles … The only thing that we kind of hit some core stuff on, that, you know …

Tony: Existing position.

Tom: Yeah, but it all worked out. Not our greatest ranged trade, but a good one.

Tony: Mm-hmm. (affirmative)

Tom: All right, let's go. Let's do Market Measure.

Tony: Okay.

Tom: You ready?

Tony: Yup.

Tom: Sorry, it just took a lot of trades to get back that …

Tony: Talking about premium selling straddles.

Tom: Yeah, and this is a great one. If you have … get a helmet bat.

Tony: Mm-hmm. (affirmative)

Tom: You're going to need it for this one, a lot of stuff. Ready?

Tony: Yup.

Tom: Market Measures, Tuesday, October 28th. Is it Tuesday? It can't be the 28th. Yeah, yeah.

Tony: It is the 28th.

Tom: Tuesday, October 28th.

Tony: Mm-hmm. (affirmative)

Tom: I can't believe my air conditioning on last night. I still can't believe that.

Tony: It was a beautiful night last night.

Tom: Really?

Tony: Yeah, it really was.

Tom: All right. Today we present a follow-up to last week's popular Market Measure. We did that one last week called, "Premium: Why Selling It Works." In that segment, we back tested 1000 strangles over a 5 year period and found, historically, selling strangles overwhelmingly outperformed buying them.

Tony: Okay.

Tom: I don't think there was any surprises there, were there?

Tony: Mm-hmm. (affirmative)

Tom: Just talking about straight performance. Today we will back test buying and selling straddles. Let's see what happens, because we talked about strangles, and then yesterday with Twitter, you got to see a great example of … potentially, you know, an opportunity to test the straddles. Remember the straddles in Twitter yesterday were trading for, what, 7? Help me here for a second. 7.80.

Tony: In November. In November?

Tom: November strangles were trading for … Was it November? I'm not sure. Now, you know what, you messed me up. I don't know. I guess it must have been.

Tony: It was November, wasn't it?

Tom: Okay.

Tony: [inaudible 00:04:11] 47.50. It's hard for me to look.

Tom: I can't really remember now. You were right, I don't know. I better check that out.

Tony: Yeah. Mm-hmm. (affirmative)

Tom: Here's a note for new tastylivers, a straddle is buying or selling a call and a put at the same strike and at the same expiration date. We generally sell at-the-money calls and puts. Which just means we're not strangle buyers. When selling … I'm sorry. We're not straddle buyers. When selling a straddle, we profit when the stock stays near the strike prices. We prefer an IV rank of above, or roughly 50%. Same stuff we've been talking about for 3 years.

Tony: I'm just looking, I think, back on the 48 and a half line in Twitter. They were trading for 7.80.

Tom: 7.80?

Tony: In November.

Tom: In November. Okay.

Tony: Mm-hmm. (affirmative)

Tom: And where is it now?

Tony: Should be … One second, Twitter. Which one do you want?

Tom: From the early close.

Tony: The 48, the 48 …

Tom: The 48 and a half line.

Tony: The 48 is going to be trading in November. The puts are 6 dollars and 20 cents and the calls are 40 cents, so about 6.70?

Tom: 6.60, 6.70, so it came in a dollar.

Tony: Correct.

Tom: So everything came in a buck.

Tony: With a 6 dollar and 30 cent move in the stock.

Tom: Right, so everything came in a buck.

Tony: Mm-hmm. (affirmative)

Tom: Basically, everything came in a buck.

Tony: There's a dollar sitting on the table.

Tom: Okay. That's fine.

Tony: Yeah.

Tom: Again, let me go through this.

Tony: Mm-hmm. (affirmative)

Tom: In the Spyders, we bought and sold a straddle, an at-the-money straddle every 5 days for the past 5 years. We used the expiring month that's closest to 45 days to expiration. We examined the P&L over the course of the trade. In study 1, we do not take into consideration implied volatility rank. We will in the other ones. Here's the results. Now, remember, a straddle is very different than a strangle. A strangle you'll get statistically a very high probability of success, but in a straddle, there's always going to be an intrinsic option.

Tony: Mm-hmm. (affirmative)

Tom: The odds change dramatically, and you'll get to see that here. Buying straddles and holding them to at expiration worked 44% of the time. Selling them worked 66% of the time.

Tony: It's going to be the inverse, right?

Tom: No. It's not the inverse.

Tony: Well, it's got to equal 100, right?

Tom: No, it doesn't equal 100. It equals 110.

Tony: Oh, you're right.

Tom: Those guys can check it and see if there's a typo or, you know, whatever. I don't know.

Tony: [inaudible 00:06:23]

Tom: Okay. I'm not sure what scratch is and stuff like that.

Tony: Mm-hmm. (affirmative)

Tom: They can look at it. Anyway, they can take a look. The average trade 134 bucks, because remember when you're going out at full, this is the Spyders.

Tony: Mm-hmm. (affirmative)

Tom: You're going out … Well, actually, these are the Spyders. These are at-the-money. Okay. 134 bucks. The average winner…

Tony: It's 34%.

Tom: 34%. Please change that, Linda.

Tony: It's a typo.

Tom: Okay. The average winner 254 if you're buying. If you're selling, 338. The average loser, same. It's the inverse of the two.

Tony: Mm-hmm. (affirmative)

Tom: Max loss, max win, and the total P&L, inverses of each other. Pretty interesting.

Tony: Yeah.

Tom: Okay, just for starters, this is selling every 5 days, regardless of IVR for the past 5 years. This is on 266 different occurrences, and if you're wondering how much capital this is tying up, this is a 1 lot. Just say the average price is, if you used 180 dollars or something like that, it would be, 20% of that … 3600 bucks.

Tony: Mm-hmm. (affirmative)

Tom: So, 3600 bucks over 5 years generated … Or, let's see, 3600 bucks over 5 years, which is just an approximation, generated 35,000 dollars from the sales side. What we did now, is we took, kind of a fun, different view, a subset of the total data set. We looked at selling straddles. The red dots, trades that ended in losses. Those are all the red dots. The green dots are trades that ended in profits. You can see the dramatic difference between the two, because you're going to get 66 and 34.

Tony: Mm-hmm. (affirmative)

Tom: Okay. Let's go back to 2011. Again, the red dots are profits, and the green dots … I'm sorry. The green dots are profits. The red dots are losses. What's interesting is, almost all the red dots, which are losses, kind of happened on up moves.

Tony: Yes. Yeah.

Tom: Right.

Tony: Well, I mean you've got a bullish market in this …

Tom: You've got to [crosstalk 00:08:18]

Tony: Time, yeah.

Tom: The risk was to the upside. Yeah, again, it just shows the same way that the straddle study, the strangle study came out.

Tony: Yeah. Mm-hmm. (affirmative)

Sold your calls in [baba 00:08:29] 420.

Tom: Now, if we could buy back our puts in X, we'll be in business.

Tony: Mm-hmm. (affirmative)

Tom: The losses, the actual move is more than the expected move, the move that the option price implied. In the gains, the actual move is less than the expected move. As you can see here, okay, look at all the green dots. That's when the actual move is less than the expected, so you get to sell something that's richer, and ultimately, it will turn out to cost you to buy it back.

Tony: Mm-hmm. (affirmative)

Tom: That's the whole game of option trading.

Tony: That's our game that we play, for sure.

Tom: Yes. That's the whole game.

Tony: Mm-hmm. (affirmative)

Tom: There's nothing else. The rest of the world ceases to exist. In the world of option trading, it's all about the actual move being less than the expected move.

Tony: That's correct.

Tom: It's a game. If you're a retail investor, that's the game.

Tony: Mm-hmm. (affirmative)

Tom: So actual loss …

Tony: You don't look for edge? That's your edge, right?

Tom: That's your edge. Yeah. You know, if you have high IV rank, that's double your edge.

Tony: Right.

Tom: Look at the greens, all the times. Then, look at the reds, and you can kind of see, you know what, the risk was on the outlier moves. The risk was on the outlier moves, mostly on the outlier up side.

Tony: Correct.

Tom: All right. Let's go … Study 2. Historically, selling straddles produced profits, but where were the profits and losses over the course of the trade? For this study, we examined 1300 straddles over 5 years, selling straddles daily. Is it normal to have a loss at some point during the trade and how can we often close at close to 50% potential profit? Because this was the question that came back to us from a crap load of e-mailers.

Tony: Mm-hmm. (affirmative)

Tom: I mean, a lot of e-mailers. Everybody was really into this study last time we did it, just it was strangles instead of with straddles. Again, for this study 1300 straddles over 5 years, daily. Is it normal to have a loss …

Tony: You know the amount of data here, it's substantial.

Tom: It's frightening.

Tony: It's substantial, yes.

Tom: It's staggering. And then, can we close at 50% max profit potential? What we did here was, we graphed this for you. It will all be on archive so you can see it. For example on February 11, 2014, we sold in the SPY for a max potential profit of 656. Before we closed the trade, we had, at one point, a draw down of 86 dollars, and then a potential profit of 343. We ultimately closed the trade at expiration for $200. Again, what we're going to look at now is … Let's take a look at how often we have losses and how often we can take profits at 50%.

Here are the results. In 89% of the trades, we had a negative P&L during some time before expiration. The takeaway here is, this goes to show you …

Tony: You think it would be that high?

Tom: I don't know. On a straddle, yes.

Tony: Right.

Tom: On a strangle, no. On a straddle, yes. This goes to show you how random the markets are, how accurate that, if you can call randomness accurate …

Tony: Accurate, right. It's almost an oxymoron.

Tom: … how accurate randomness is, because that 89% is probably very close to what we call probability of a touch. If you sell a straddle, there's a 50/50, assume there's close to 50/50 … If you're 50/50, that means your probability of touch is going to be close to 95%. It's coming in at 89%. It's right there, as far as opportunity for negative P&L.

Tony: Of what you'd expect, yeah.

Tom: On the straddles, 90% of the time you're going to have a negative P&L at one point. Our average lowest draw down in P&L is 199 bucks and our average highest P&L is 313. In 44% of the trades, we were able to close with at least 50% max profit. What's cool about this is, because again, I'm going to get back to this whole randomness discussion, these numbers we do. If you take 89%, and you divide by 2, it's about 44 1/2 %. What we're basically saying is that probability of a touch … Not only does probability of a touch work, but managing winners at 50%, okay, and you can kind of see how accurate this is. In 44% of the trades we were able to close with at least 50% max profit.

Tony: It works time and time again.

Tom: Okay.

Tony: Mm-hmm. (affirmative)

Tom: It's just, this is the future of finance for everybody. If you know something, if you have a 50/50 shot. Again, it could be off by a couple pennies, whatever it is.

Tony: Mm-hmm. (affirmative)

Tom: If you have a 50/50 shot, you're going to come in close to probability of touch, somewhere in that 90, 95, 97%, depends, just depends on [N-Y 00:12:49]. If half of those trades, you can manage at 50%, just think of how rich that trade is by definition.

Tony: Sure.

Tom: By definition.

Tony: [crosstalk 00:13:01] you have that much opportunity, right?

Tom: Well, because selling strangles works, whatever we said before, right. 65% of the time, whatever it is.

Tony: Mm-hmm. (affirmative)

Tom: You have … I'm sorry. Because actual is less than implied 50% of the time. This is a fascinating discussion of, 1, the percent of draw down, percent of times you're losing, which is another reason you don't do stop orders. Because if you use stop orders, you'll be stopped out as soon as you have a loser.

Tony: Mm-hmm. (affirmative)

Tom: How does implied probability rank impact the profitability of these straddles. For this study, we're going to examine 1300 straddles over 5 years, again. Now, below, these are the results of straddles when you're below 50% IVR, and when you're above 50%, huge difference, 12% different. The average trade, almost 4 times as much, the average winner almost double, the average loser, it was even less.

Tony: Correct, and that's what 12% does for you. That's what a high IV does for you with 12% more wins. You're talking about 4 times, almost 4 times as much money. 4 times as much money.

Tom: This is one of the coolest studies we've done because it shows you what your expectations should be for a loss at some point, which is almost 90%. It also shows you how much of an advantage you have by selling high IV rank. Then it gets into just the straight numbers.

Tony: But look at how much more money you make when you bring something in from 65% to 75%. It's amazing.

Tom: Yeah.

Tony: Because, ultimately, that's what counts, right?

Tom: Yeah.

Tony: I mean, how much money you have in your account, right?

Tom: Yeah. All right. Let's keep going. We don't have much time.

Tony: 10% makes a big difference.

Tom: Here's the takeaway. Historically, selling straddles results in wins 66% of trades. Whereas buying only works 34% of the time. High IVR mattered when selling straddles, more than it did when selling strangles. In 89% of trades, we had a negative P&L at some time during the trade. These are monster takeaways. Again, let me go through them again.

Historically selling straddles … Remember, now straddles are 50/50, close to 50/50. I mean, we're talking about selling an at-the-money put and call.

Tony: Sure.

Tom: It works 66% of the time. Okay, you have to be able to explain that, because that's the …

Tony: Well, you have to see the advantage to it also.

Tom: Okay. High IVR mattered because you went from, whatever it was, 64% to 76% winners, and 89% of trades, we had negative P&L. That's reasonable expectations. Next one. 85% of the winning trades had a negative P&L during some time during the trade. Even though our risk appears higher with the larger IVR, which is IV rank, on average our probability of success appears higher and our average trade is more profitable.

Tony: Listen, it sums it up pretty nicely.

Tom: There's a lot of crap in here.

Tony: Mm-hmm. (affirmative)

Tom: Okay, you got to work your way through this a couple different times. Let's go back just one slide, and sum up the takeaways, because if you're at all interested in selling straddles. If you're looking, for example, at Facebook this, you know, Facebook was down this morning a little bit. Now it's up a little bit. If you're looking at straddles, like the 80 … Where is Facebook? Oh, it's 81 already.

Tony: Mm-hmm. (affirmative)

Tom: If you're looking at this, okay, we're talking about 66% of the trades versus 34% buying, and everybody always comes out and talks about buying straddles.

Tony: It's amazing, right?

Tom: Drives me out of my mind.

Tony: Mm-hmm. (affirmative)

Tom: Okay. High IVR. 89% of the trades have negative, or are negative at some point. 85% of the winning trades are negative P&L, even though the risk appears higher. There was huge advantage to selling high IVR.

Tony: Yeah. Listen, I want to go, just 1 more time, I want to go back to, like, slide 11 there. From my own, personal standpoint, I get a lot of e-mails from people saying, "You know what, I'm managing my winners. I'm doing well." You know, they don't typically give me their percentage of winners, but they say, "I'm making money, but I don't feel like I'm making enough money." Then, the next e-mail come out and say, "I'm managing winners, I'm reinvesting money at 50%," and not telling me what the percentage of winners are, and saying, "You know what, I'm really hitting it out of the ballpark. I didn't imagine it was going to be this good." The difference could be as little as a 10% change in your percentage of winners. All I'm trying to say here is you just got to keep honing the skills, honing the skills, and staying in the trade. You looked back on a slide just a moment ago 80-some-odd percent, almost 90% of the trades had a loser at some point. That's amazing statistics.

Tom: For years and years on the trading floor, and I'm sure Tony was in this exact same position, there was a group of traders, not partners or anything like that, just this group of maybe 10, 15, 20 traders on the CBOE floor, and this was not one of the commodity floors. This was just a pure option floor, where we used to look at them. We'd go, "Wow. This guy's good." Now, we were the grinders.

Tony: Sure.

Tom: We went and sat in there every day, you know, made every market you want.

Tony: Banged it out.

Tom: Tried to grind it out, just scout them, whatever it was.

Tony: Mm-hmm. (affirmative)

Tom: There's these guys that were come into the markets and they'd be like (sound effect), and the next thing you know.

Tony: They'd disappear.

Tom: They would disappear, and what I noticed over the years was, it was always the same group …

Tony: Mm-hmm. (affirmative) Mm-hmm. (affirmative)

Tom: Of really good traders. I used to think, what do these guys know?

Tony: Right.

Tom: I never could figure out what they knew, because they didn't know anything.

Tony: They didn't know anything more than me.

Tom: They didn't know anything more than us.

Tony: Right, right.

Tom: Nothing more. What they knew was, what's on here.

Tony: Mm-hmm. (affirmative)

Tom: What they'd figured out on the back of the envelope, at home, whatever it is.

Tony: Wherever they do that.

Tom: However they did it. Plus, they had to be mechanical and the rest of us weren't.

Tony: It's true.

Tom: The rest of us were very emotional.

Tony: Mm-hmm. (affirmative)

Tom: They were mechanical. The mechanics, over the years I've recognized that the mechanics are so important, but first we had to build the technology to allow you to execute the mechanics. Now that you can execute the mechanics, you know, now you can do, now everybody can do this.

Tony: Mm-hmm. (affirmative)

Tom: I don't know. It's extremely interesting. Let's put it that way.

Tony: Awesome. Let's take a quick break. We'll come back. We got a game changer next. We're talking about strike widths versus days to expiration. This is tastylive LIVE!