PurelyTechnical

The diagram (on right) depicts the time value component of a given option, as it nears expiration. As can be seen, the option’s time value decays at a faster clip in the last few weeks before expiration than it does in the first few months of existence of the option. This fact is immediately apparent when comparing the time value decay line with the broken line that depicts a linear rate of decline.

Now, the diagram on the right plots time value at intervals of one month. A diagram that depicts time value by week - or by day - would show a similar rate of increase in time decay with each passing week/day.

In other words, if you're holding options into the last week, you need the stock to move pretty much according to plan, or else you need to close out the position almost immediately - or find an appropriate way to repair the strategy.

In the webinar, we'd mentioned that unless you're willing to take a big risk, you'd want to exit the positions by Wednesday, which was the third day before expiration.

What was so special about Wednesday?

It was selected as the cut-off point because of a variety of factors, including a scrutiny of the payoff diagram, the proximity to expiration and the fact that the stock would have had enough time to "perform" by that point (and if the stock had not moved in a suitable by that manner, it would probably have to have been assumed that it was not moving within the parameters that we had envisioned.

As it turned out, NOV and OXY had not moved far enough away from the respective strikes to have brought about a big profit, but the Straddles were showing a gain of 9% and a loss of 6%, respectively. The charts below depict price action as of the close on Wednesday; the value of the each of the straddles has also been mentioned, in each case).

What becomes evident immediately is that while the stocks did move a decent amount between their opening, mid-morning on Monday, and the close of trading on Wednesday, they ended up moving to the upside - and through the respective strikes - instead of away from the strikes. Had we seen a similarly-sized move away from the strikes, the original trades would have brought about a pretty decent profit.

That is because their intrinsic value would have increased by a large enough magnitude to have offset the inevitable decay in time value.

The following diagram depicts the theoretical values of the Long AUG 75.00 straddle on OXY, on each day of the four days leading into expiration. The diagram assumes that implied volatility held steady into expiration, which was pretty much what happened anyway.

One of the things that we'd like to convey through this diagram is the concept of the "profit zone" and how important it is to constantly have a feel of where the profit zone(s) lies on each of your options positions.

The black line depicts the profit or loss as of expiration, based on a price of 3.25. The other lines represent the theoretical profit/loss as of each of the prior 4 days.

As the diagram shows, the upper breakeven (at expiration) was at 78.25 and the lower breakeven at 71.75. Now, it can also be seen that profitability could have been attained had the stock been trading just above 71.75 or just below 78.25 in the days before expiration. However, were the stock to have been stuck in the region between 73.50 and 76.50, there would have been losses and the magnitude of the losses would have grown with each passing day.

We'll go more in-depth into this and dozens of other topics in the Options Coaching that will be made available to you starting in the second half of September, but for now we'd like to leave you with a conceptual feel of the effect of the passage of time on the value of a Straddle.

This fact can easily be seen on the p/l diagram, above. Take a look at the respective p/l lines and the levels at which they intersect with an underlying price of 75.00 (the strike of the straddle in this example). Notice that each successive line is farther away from the one above it, than that one is from the one directly above. In a nutshell, the position is losing more and more with each passing day and, as such, it is crucial for the stock to move in the desired manner as quickly as possible (especially if expiration is quite near.

So what do you do, if the stock does not move quickly towards one target or the other?

In such a scenario, the easiest choice is to close off the position and move on. However, if there is the scope to do so, a repair strategy might often be beneficial.

We'd talked briefly about this in the webinar and would like to expand on it a little bit in this follow-up article. We often use repair strategies on straddles, strangles, strips, straps and other strategies that are featured in the Options Picks section of the Members Area. What follows is a brief look into how one of the potential repair strategies, specifically discussed in the webinar, could have been used to turn the underperforming OXY Straddle into a potential winner.

Repair Strategy

Let's take a look at the setup on OXY, near the close on Wednesday, and then try and arrive at a potential repair strategy for the trade. Now don't get caught up in the details of this particular trade, rather try and get a grasp of the conceptualization behind the search for a repair strategy on a given Straddle.

So, what can we glean from the chart, above?

The first thing that we notice is that prices had hit the falling upper line of the symmetrical triangle intraday on Wednesday, found resistance from the same and closed just below the line, at around 78.13. One of the most basic characteristics of the symmetrical triangle is that prices oscillate between the converging trendlines, until there is an eventual breakout.

When resistance was found on Wednesday, the trader would have realized that there are two potential outcomes above all others: a) price could break out of the triangle imminently, or b) prices could find resistance at the upper line and fall quickly towards the lower line.

Now, if outcome (a) were to occur, the trader would not have had to worry because that would probably mean that a quick move to 80-82 or above could take place within a day or two. And, given that the upper breakeven (of the original position) was at 78.25, such a move would have been most welcome.

However, if outcome (b) were to take place, the trader would be very disappointed. The lower line was projected to move to 73.60-73.75 on Thursday and Friday. If you look at the p/l diagram provided earlier, such a move would have meant a loss of 30-60% on the original position. Such a move would not have been a good outcome.

Here is where the ability to astutuely morph (or "repair") a trade comes to the fore...

Okay, so let's look at what we have to contend with now.

1) There is the potential for a move to 73.75, which would be a bad outcome, given the original position. Can we find a modification to the strategy that will bring about a chance for profitability - or at least breakeven - if the stock were to move back to the lower line?

2) If the stock breaks above falling resistance at 78.25-78.50, we'll be looking at a decent profit on the trade. How can we ensure that any strategy that we come up with considering point (1), above, does not grossly hinder the chance to attain profitability in the event of an upside breakout?

As you might imagine, it would have been rather easy to find a solution to (1). For example, the trader could have considered closing off the Long 75.00 Calls, which were trading at 3.25 at the time, and just held onto the Puts. Doing so, would have ensured that at least a breakeven would have occurred (you'll remember that the entire straddle was purchased at 3.25). If the stock were to have then fallen to the lower line, the Puts would have been trading at 1.25 or slightly better (because they would have been trading 1.25 points in-the-money).

The drawback using that exit strategy would have been that the trader would have lost the opportunity to collect profits if there were to have been a breakout to the upside.

As such, the trader might have been on the lookout for another strategy...

One strategy that we often use in the Options Picks section of the Members Area is to convert an underperforming Straddle into a Strip or a Strap, in order to beef up the position's downside or upside exposure.

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In case you were wondering...

What is a Strap?

A Strap is a modification of the Straddle; it is an options strategy often used by experienced options traders. The Strap is similar to the Straddle in that it has Long Calls and Long Puts on the same strike price and expiration month. However, the difference is that in the case of the Strap, there are more Calls than there are Puts in the position (typically 2 Calls to every Put). This structure gives the Strap a bullish bias.

What is a Strip?

A Strip is a modification of the Straddle; it is an options strategy often used by experienced options traders. The Strip is similar to the Straddle in that it has Long Calls and Long Puts on the same strike price and expiration month. However, the difference is that in the case of the Strip, there are more Puts than there are Calls in the position (typically 2 Puts to every Call). This structure gives the Strip a bearish bias.

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Now, we'll leave the in-depth explanations behind the topic of choosing a ratio and when to convert a Straddle into a Strip and when to convert one into a Strap, for the Options Coaching classes scheduled to begin next month, but for now just take our word for it that considering that we are looking to beef up the bearish side of this trade (without losing upside profitability), converting to a Strip is the way to go. A few back-of-the-envelope calculation - simple to do really (we'll show you how, in the Options Coaching classes) - shows that converting the Straddle to a 1:3 Strip, by buying 2 more Long AUG 75.00 Puts, which were trading at 0.20 at the time, would have allowed for the sort of payoff diagram that we would have been looking for.

Adding 2 AUG 75.00 Puts to Convert Position into a Long 1:3 (Calls: Puts) 75.00 Strip...

The aforementioned repair strategy would have provided the following payoff structure:

The first thing that you notice from the new p/l diagram is that the lower profit zone has expanded; i.e. the lower breakeven has risen to, voila, 73.75 give or take a couple of pennies.

The adjustment does increase the total capital outlay - and potential loss - from 3.25 to 3.65, if the position is held until expiration, but it drastically improves the lower breakeven point.

A reading of the diagram and a couple more basic calculations would have told the trader that if the stock had touched the lower line at 73.75, the puts would have been trading at 1.25 (probably a little more) and that he could have sold all the (three) Puts at a total 3.75 or more. That would have meant that there would have been a guaranteed profit of 0.10 (3.75-3.65) or more and there would still have been the chance for a collection of profits on the Calls, if the stock were then to bounce off the lower line. (This scenario was exactly what happened, as the chart below shows, and the trader would have been left with a profit of 25% or so on the trade, had he played it well).

Now let's play devil's advocate and say that the stock could perhaps have ended up breaking resistance and moving towards higher levels. Wouldn't all the Puts have gone into a loss?

Yes, they would have. However, the adjustment would still have been worth it because the Calls would have nevertheless gained in value given such a scenario. If you look at the new p/l diagram (above the stock chart that you see directly above), you'll notice that there would have been a profit of 50% had there been a brekout to, say, 81 instead.

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The illustration above goes to show that options are extremely versatile and that a trader who takes the trouble to learn the basics (and mind you that's something that anyone with even just a high school education can do) can take what might seem like a completely hopeless situation to the novice and turn it into a big opportunity.

Forgive us for not providing you with exhaustive details about how exactly we arrived at the specific ratios and repair strategies, but this exercise was conducted with a goal to provide a taste of some of the strategies that are utilized by the experienced options trader who has taken the trouble to get the basics right...

...also to give you a taste of the type of material that will be covered in the soon-to-be-introduced Options Coaching classes.

We've drafted up a tentative curriculum for the courses that will be offered. Please contact us using either the contact forms on the blog or one other parts of the site, if you are interested in receiving a copy of the curriculum or have other questions pertaining to the upcoming classes or the recent webinar.

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Best of luck with your trading!

Regards,

President

TheMarketMessenger.com