Tuesday, November 17, 2009

Weber & Zieg, The Complete Guide to Non-Directional Trading

Contrary to the title, Heinrich Weber and Kermit Zieg, Jr. have not written The Complete Guide to Non-Directional Trading (Traders Press, 2005). Don’t look for insights into butterflies or condors, for instance. The authors instead provide an introduction to volatility (with helpful visuals), the seemingly mandatory discussion of covered calls, and an analysis of straddles.

I’m going to focus here on Weber and Zieg’s study of straddles, which the authors contend is the best way to trade volatility. A straddle, just to get everyone on the same page, is a call and a put on the same stock with the same strike price and the same expiration. A long straddle is long one call and long one put; a short straddle is short one call and short one put. The risk profile for a long straddle looks like a V; the risk profile for a short straddle looks like an A. The rationale for trading straddles is to place a bet on volatility, not on direction. Long straddles have a defined risk and unlimited profit potential; short straddles have unlimited risk and defined profit potential. Holders of long straddles are hoping for huge moves in the price of the underlying; holders of short straddles are hoping for small moves.

The authors outline rules for success in trading straddles. Let me mention two in connection with long straddles. First, buy double the time. That is, analyze price movement over a relatively short time—say, six weeks—and buy a three-month straddle. The idea is that even if volatility comes in temporarily, the trader has twice as long for price to move by the desired amount. Second, pay very little. This is important because straddles tend to be expensive. Ideally, the trader would pay no more than one-third of the spread (in our example, over the previous six weeks).

And now for my caveat, not a criticism of the book per se but a warning for its intended novice audience. I’m certain that there are highly successful straddles traders. But I would urge all but the most skillful options traders to resist the siren call of straddles. It’s far too easy, for instance, to get caught in the trap of buying a straddle just ahead of earnings (admittedly, the authors would keep you out of this trade because the premium would be far too high), have the stock price move as anticipated and implied volatility implode. And, guess what, most likely you lose!

Trading options often seems like navigating a minefield. It requires knowledge, skill, and luck. If you can minimize your defined risk you stand a shot of coming out alive. If your risk is high, even if your potential rewards are astronomical, your odds of surviving are slim.

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