Strategy Of The Month

The Strategy: Long Straddle

Description: A long straddle is an options spread constructed by purchasing both a call and a put option at the same month and expiration.

Greeks Bias: The spread is non-directionally biased, it benefits from a large move in price in either direction. It is negative theta, so time decay will affect the position, and long vega and gamma, so volatility sensitive.

Profit Potential and Risk: The maximum risk with a long straddle is the premium paid. The profitability is unlimited given the potential for extended price movement, similar to being long calls or long puts. The break-even price for the position is calculated using the total premium paid either added to the call leg or subtracted from the put leg (for example: a $20 straddle purchased for $2 would have break-even points at $22 and $18 respectively). The position can be re-balanced throughout its life. If price spikes in one direction, a trader can sell some of the call or put options held to make the position delta neutral again.

Break-Even Points: Breakeven Points are the Strike Price of the Long Call/Put + the Debit Paid. A move outside of those levels is profitable, while shares within those constraints results in a loss.

P/L View:

Market Conditions to Apply: Low Volatility Environment with Signs of Complacency.

Screening for Candidates:

The long straddle is best utilized either in names which have seen near-term volatility stagnate versus the historical norm or when shares have traded in a tight range over a period of time and price has become compressed in high kurtosis. It can be an excellent way to position for an event including earnings announcements, FDA decisions, and court rulings. Some practical ways of finding long straddle candidates include technical scans (Bollinger Band width, ATR, Standard Deviations), comparing volatility spreads such as IV30 vs HV20 and HV180, the data of which can be found on platforms like Live Vol or Bloomberg, and some stocks even have individual volatility indices similar to the VIX including Apple (VXAPL), Amazon (VXAZN) or IBM Corp (VXIBM).

Putting It Into Practice: Johnson & Johnson is a prime example of using the long straddle which encompasses both low volatility as well as a potential event-driven scenario. The $277.89B company trades 15.64X earnings, 3.87X sales and 4.15X book value with a 2.99% yield. Earnings are set to grow in the low single-digits over the next five years, slowing from the prior year. Shares have traded in a tight range between $103 and $98 all year and their weekly Bollinger Bands have contracted to 4.75, the tightest width since November 2012 before shares went on a prolonged run higher. The ATR (14) is 1.068 on a daily timeframe, historically low. IV30 is 11.5%, depressed relative to HV180 which is 14.8%. Johnson & Johnson (JNJ) recently was reported to be nearing a deal to buy Pharmacyclics (PCYC) for around $17.5B, the largest M&A purchase the company has done since buying Synthes in 2012 for $19.7B. The deal fell through however as AbbVie (ABBV) made as superior offer. JNJ rarely does a big deal but their willingness to go after PCYC signals that they are willing to spend for the right scenario. M&A would likely kick-start shares out of this recent range. On Friday, Wells Fargo was out positive shares as they believe the company’s pharmaceuticals business will show strong growth in Q2. Institutional ownership fell 2% last quarter. Short Interest is 27.8M shares, down from recent highs of 31.7M shares.

Other names where the preceding conditions apply but require further analysis: STZ, MDT, and BC.