pdsro's  Instablog

In the option universe there are several investment strategies. The one I want to talk today is the straddle and strangle.

The straddle strategy is a nondirectional strategy. It consist on a purchase of a call and a put at the same strike price and expiration month because one expect a large price breakout but not sure of the direction. 

With this strategy one makes money if the stock moves up or down beyond the breakeven points by expiration. Normally one would want as much time as possible to expiration to give the stock time to make a large move in either direction and reduce effect of time decay on both options. 

The payoff of the strategy generate a limited risk to the combined debit paid but a maximun reward unlimited on the upside and limited reward on a downside because price can't go less than 0.And the breakeven points is the strike price +- total debit paid. The following graph represents the payoffs one would receive if it uses this strategy.


Otherwise, the long strangle is very similar to straddle strategy but it have lower cost than a long straddle but requires an even greater move in the stock in either direction to be profitable because the strike price of the put and the call are different. The payoff graph is presented next. See the difference with the long straddle?



In sum, both strategies imply a bet that the stock would be very volatile. With this idea in my mind I thought: What stocks are the most volatile always? The answer: Direxion ETF's. I mean always because with some event the stock could be volatile but not necessary one knows that this event would ever occur.

The Direxion ETF's have a 3x leverage, that means that if the target index goes up 1% the ETF would go 3% or -3% on a daily basis (it depends on what ETF you have). A lot of ariticles had pointed that long term investments on leverage ETF, like Direxion ETF's, are very risky because daily volatility affects long performance. So if the benchmark index goes 10% on a year it doesn't mean that the return of the ETF will be 30% on the same period. Daily volatility changes this concept. Even Direxion and Proshares, both ETF leverage funds managers, say that.

However, using the straddle or strangle strategy with this ETF's one can have a very high return because it makes the weakness of long term investment into a strength. The daily volatility make very unusual to leverage ETF's be at the same price, or a near range, on a short/medium and long term. Applying this strategy constantly will, with a lot of probability, make you earn a high return. And why not just a put or a call? Because no one can predict the future. Moreover if the ETF have a daily leverage. Just use what you know: (1) Option strategy allows you to earn profits when the underlying asset is very volatile and (2) Direxion ETF's are very volatile beacause of its high leverage.

Take FAS as an example. It's monthly change (%) on 4 of 6 months are more than +-20%.



But remember: capitalize gains. Not wait until expiration if you think a high return is reached. Instead sell your contracts and don't be overambitious.