The China-U.S. talks are coming! Options strategy under volatility expectations.

There is an event worth paying attention to in the past few days. A spokesperson for the Ministry of Foreign Affairs announced that at the invitation of the United Kingdom government, He Lifeng, a member of the Political Bureau of the CPC Central Committee and Vice Premier of the State Council, will visit the United Kingdom from June 8 to 13. During this period, the first meeting of the China-U.S. economic and trade consultation mechanism will be held with the U.S. side. Any developments beyond market expectations will impact market volatility.

When determining a significant event, the market will experience substantial short-term fluctuations, but the direction of the fluctuations is unclear, as it could either surge or plummet. In such cases, it may be worth considering the use of a Long Straddle options strategy.

1. Strategy Overview

1) Strategy Composition

"Buy Put" + "Buy Call"

The underlying assets, strike prices, expiration dates, and contract quantities for both Call and Put are exactly the same.

When the stock price rises sharply, although there is a loss in the "Buy Put" part, there is a gain in the "Buy Call" part, resulting in an overall positive return.

When the stock price falls sharply, although there is a loss in the "Buy Call" part, there is a gain in the "Buy Put" part, resulting in an overall positive return.

2) P/L Analysis

Source of profits: simultaneously buying Put and Call, gaining from "Buy Put" when the stock price falls, and gaining from "Buy Call" when the stock price rises.

Regardless of whether the price rises or falls, as long as the increase or decrease is large enough to cover the losses on one side with the profits on the other, this strategy can be profitable.

3) Strategy Features

Expectation: significant rise or significant fall. If there is an expectation of a drastic change in stock prices but uncertainty about the direction of that change, the Long Straddle strategy can be constructed.

Unlimited profits: As you are the buyer of both puts and calls, you can gain profits regardless of whether the stock price goes up or down. The larger the increase or decrease, the more profit you earn.

Limited losses: When the stock price equals the strike price, both options are out of the money, resulting in a loss of the entire premium. Maximum loss equals the total premium.

Volatility: This strategy belongs to a long volatility strategy. If the underlying asset price does not change much by the expiration date, you may lose the entire premium, so it is more suitable to be constructed when the IV is relatively low.

Initial cost: relatively high, as both Put and Call are bought simultaneously, requiring payment of two options premiums. At expiration, one option will definitely expire worthless, so to achieve a positive return, the volatility of the Stocks must be sufficient.

II. Case Study

Assuming a significant macro event will occur next week, it is believed that the price of TUTU will also fluctuate with the market, but it is unknown whether it will rise or fall.

Currently, TUTU's stock price is $50. In anticipation of the potential large fluctuations next week, both a call option (Call) and a put option (Put) with a strike price of $50 were purchased simultaneously, thus establishing a Long Straddle strategy.

If the stock price rises sharply, the portion from the 'buying the call' will profit. If the stock price falls sharply, the portion from the 'buying the put' will profit. The greater the extent of the stock price increase or decrease, the greater the profit earned.

Your Hold Positions cost:

Cost of 1 put option: the unit option premium cost is -$3, with a total option premium cost of -$300.

Cost of 1 call option: the unit option premium cost is -$2, with a total option premium cost of -$200.

Therefore, the net premium for buying two options is -$5, with a total premium of -$500.

1) Scenario one: Stock price drops significantly

At this time, the call is out of the money, while the put is in the money.

If you choose to exercise the put, you can sell TUTU stocks at a lower price of $50. The greater the decline in stock price, the higher the收益 from exercising the put.

When the stock price drops to the point equal to the total option premium cost, i.e., when the stock price = 50 (strike price) - 5 (total unit option premium cost) = $45, the stock price reaches the breakeven point 1. Beyond this point, as the stock price declines further, the strategy achieves higher positive returns.

You can also choose to close the position midway. When the stock price drops significantly, although the price of the call options decreases, the price of the put options increases even more. At this point, you can sell the entire portfolio at a higher price to achieve positive returns.

2) Situation Two: The stock price surges.

This is exactly the opposite of Situation One, where the call is in the money and the put is out of the money.

If you choose to exercise the call, you can buy the higher-priced TUTU stocks at $50. The greater the increase in the stock price, the higher the return on the exercised call.

When the increase in stock price equals the total options premium cost, that is, when the stock price = 50 (exercise price) + 5 (total option premium cost per share) = $55, the stock price reaches the breakeven point 2. Thereafter, as the stock price rises further, the strategy yields higher positive returns.

You can also choose to close the position midway. Similar to Situation One, when the stock price surges, although the price of the put options decreases, the price of the call options increases even more, so this strategy maintains positive returns at an overall level.

3) Situation Three: The stock price fluctuates slightly.

When breakeven point 1 < stock price < breakeven point 2, due to the stock price fluctuating only within a small range, whether exercising the put or the call, the returns are insufficient to offset the cost of buying the options, you will incur losses.

When the stock price equals the strike price, both options have no exercise gain, you need to bear the entire expenditure of buying the options, resulting in a maximum loss of $500.

If you choose to close the position, due to small fluctuations in the stock price, the value of the options will decline over time, leading to a total premium of the portfolio being less than the cost when buying, thus you need to incur a certain loss.

Three, Operation Guide.

1) Situation One: No related holdings, simultaneously Buy Put + Buy Call.

If there are no related holdings, you can click on the [Options Chain] below and select [Strategy Builder] to enter the trade. Click the top right corner to switch to [Buy], and the system will automatically help you buy one Put and one Call simultaneously, thereby forming a Long Straddle.

2) Situation Two: Already hold one option, just need to buy another.

If you already hold a Single Option (such as Call), then click on [Single Option] to buy another option with the same strike price but the opposite direction (such as Put), the system will automatically recognize and build a Long Straddle. However, to ensure delta neutrality, generally, both Call and Put are purchased simultaneously.

IV. Practical Application

Strategy Core: Delta Neutral + Vega Long

Delta Neutral means that the strategy maintains neutrality towards market trends (up or down), while a long Vega indicates an expectation of rising volatility, meaning significant price fluctuations are anticipated in the market, either upwards or downwards. This strategy is commonly used in situations where a significant event is expected to trigger substantial market volatility, especially when the specific direction of price change is unpredictable. By simultaneously holding calls and puts, profits can be made from strong trends in either direction, as long as the price movement is large enough.

Long Straddle is also used in intraday trading. Generally, market volatility tends to increase during the period after the market opens or just before it closes, making stock prices unpredictable. By constructing a Long Straddle strategy, one can capture intraday price movements with minimal time value erosion. If market volatility is limited, potential losses are relatively small because intraday trading aims to close positions within the same day. However, if market volatility is significant, investors can gain returns. The risk-reward ratio of the Long Straddle strategy in intraday trading is relatively good.

5. Frequently Asked Questions

A. How should I choose the strike price?

Most investors tend to buy at-the-money options (ATM), meaning the strike price is close to or equal to the current stock price. The benefit of this approach is that the positive Delta of the Call and the negative Delta of the Put can almost offset each other, ensuring the strategy's Delta neutrality.

B. How should I choose the expiration date?

Most investors usually choose the expiration date based on budget constraints, as options become more expensive the further out the expiration date is. Given the high cost of constructing a Long Straddle, and to mitigate the impact of time value decay, shorter expiration dates are often selected.

C. If the strategy is profitable, how should I take profits?

When a Long Straddle is profitable, it usually indicates that the stock price has experienced significant one-sided volatility. Since the premiums of Call or Put options decrease over time, if a profit has already been made, it is possible to choose to close the Long Straddle early to take profits, without needing to hold until expiration, which can avoid further depreciation of time value.

D. If the stock price fluctuates little or the IV declines, and the strategy incurs a loss, what measures can be taken?

Method 1: Close Positions Timely

When volatility is low, Call and Put options will quickly lose value as time passes. To avoid losing the entire option premium, one can actively close positions before expiration. Although the option premium has declined at this time, some losses will be incurred, but this is better than losing the entire option premium.

Method 2: Adjust the Strategy

For those more conservative investors, if willing to sacrifice some potential gains while limiting the maximum loss, consider transforming the strategy into a Long Iron Butterfly.

The specific operation is based on the Long Straddle, selling out-of-the-money Call and Put options on both sides. The income from the options premiums offsets the losses, reducing the overall strategy's maximum loss, but the corresponding profit potential is also compressed.

Method 3: Roll Backwards

This is an upgraded strategy for closing positions. The specific operation is: Sell the current Call and Put to close positions, and Buy new Calls and new Puts with a longer expiration date. The new options contracts can be chosen to have the same strike price as before or adjusted up or down based on the actual changes in stock price. This allows the strategy more time to wait for significant fluctuations in stock price.

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