Straddles the Safest Strategy?

I received this enquiry from one of the members of Aussie Stock Forums which I reproduce with permission:

Hi Wayne

You're an options man so I wonder if you'd mind answering a query. I'm relatively new to options and I've still got a lot to learn, but I've been going quite well with bought puts on US stocks. There's something I'd like to clarify. I've heard that the safest way to trade options is to buy a put and a call at the same time, i.e. a straddle or a strangle, effectively giving yourself a bet each way.
I can see the possible benefits of such a strategy if a stock is flat and there's an earnings report due and you're expecting it to jump one way or the other, but you're not sure which way. But surely the same strategy doesn't make sense if your stock is in a strong trend, has retraced briefly for a few days against the trend, and is now giving every indication that it's about to resume it's trend with a vengeance?
I mean, not only does it put your cost up considerably, but it also kills your profit to a some extent as one of the options would gain rapidly while the other one lost value rapidly (assuming that the stock does in fact make the expected trend resumption).
I guess you could unload the unprofitable one, but if the stock has made a decent move then the unprofitable option would already be showing a hefty loss which would eat into the profit of the other one. Furthermore, if you quit one of the options then it seems to me that you're removing your safety net if the stock was to suddenly reverse and move counter to the trend.
But on the other hand, would you really want to be in an option that was making money only because the stock was moving in the opposite direction to what you expected, i.e. against the trend? I mean, counter-trend moves tend to be short lived.
So, considering the above factors, my thinking is that just a single bought put is the best way to go if the stock is trending strongly but is currently retracing, yet showing sings of imminent trend resumption.

An example of what I'm talking about, the US stock BSC was downtrending strongly when it bottomed out on 9th January, then rallied for a couple of days before topping on January 11. The rally stopped near the Fib 38.2% retracement level, then BSC put in a small range inside day. According to my analysis, this was a good shorting signal if it traded below the inside day.
Now in this situation where the odds are heavily in favour of the stock resuming its downtrend, I can't for the life of me see any reason to buy a strangle or straddle, instead of just buying a single put. With just a single option, if it goes against me I can have a stop in place to minimise my loss. If it goes my way, it has the potential for considerable gains.
Is my thinking correct here, or am I, in my experience, missing something? I'd appreciate your views if you have time to give them.

It's a good question, and one that every options trader ponders as they go on their journey of discovery of this sometime bewildering trading instrument. There are a few concepts to deal with, perhaps if I cover with them one point at a time:

I've heard that the safest way to trade options is to buy a put and a call at the same time, i.e. a straddle or a strangle, effectively giving yourself a bet each way.

I get very annoyed when I see questions like this; not at all at the people asking the question, they are just trying to learn in what is quite a complicated subject. I get annoyed at the ersatz"experts" who spout rubbish like x is the safest strategy, or y is the best strategy.

There is no such thing as the safest or best strategy, there are only strategies that suit your market view, the way you like to trade and volatility conditions. The straddle and strangle are simply strategies for option traders to have in their armoury, to implement when they think it appropriate.

I can see the possible benefits of such a strategy if a stock is flat and there's an earnings report due and you're expecting it to jump one way or the other, but you're not sure which way.

Bear in mind that just about any option strategy intrinsically contains a bet on volatility. This is doubly so with the straddle or strangle. The expected move in the underlying must be greater that that implied by the options price, AKA implied volatility. To see what can happen with regards to implied volatility in this instance see my post - Nike Straddle - Just Do It.

But surely the same strategy doesn't make sense if your stock is in a strong trend, has retraced briefly for a few days against the trend, and is now giving every indication that it's about to resume it's trend with a vengeance?
I mean, not only does it put your cost up considerably, but it also kills your profit to a some extent as one of the options would gain rapidly while the other one lost value rapidly (assuming that the stock does in fact make the expected trend resumption).
I guess you could unload the unprofitable one, but if the stock has made a decent move then the unprofitable option would already be showing a hefty loss which would eat into the profit of the other one.

This illustrates my point about selecting strategies to suit your view and the way you like to trade. This trader has a clear scenario that he wants to trade and should it play out as envisaged, the straddle or strangle would be suboptimal. This trader wants a strategy with negative delta, not delta neutral like a straddle/strangle. This not to say that the straddle wouldn't suit another trader with a different view. It is a matter of understanding the strategy, the greeks, the risks, the potential reward, selecting and implementing a strategy that suits.

I mean, counter-trend moves tend to be short lived.
So, considering the above factors, my thinking is that just a single bought put is the best way to go if the stock is trending strongly but is currently retracing, yet showing sings of imminent trend resumption.

An example of what I'm talking about, the US stock BSC was downtrending strongly when it bottomed out on 9th January, then rallied for a couple of days before topping on January 11. The rally stopped near the Fib 38.2% retracement level, then BSC put in a small range inside day. According to my analysis, this was a good shorting signal if it traded below the inside day.
Now in this situation where the odds are heavily in favour of the stock resuming its downtrend, I can't for the life of me see any reason to buy a strangle or straddle, instead of just buying a single put. With just a single option, if it goes against me I can have a stop in place to minimise my loss. If it goes my way, it has the potential for considerable gains.

In this instance, with this view, a simple bought put could be the ideal strategy to suit this view. The long put is short delta, long gamma, long vega, perfect for a strong down move. The risk is that IV was already quite high and should the stock go against the trader's position, there would be some volatility crush as well. If this risk is acceptable to the trader, perfect.

My view and not to be considered as advice yada yada yada.

Nike Straddle - Just Do It?

Todays posts have reminded me of an interesting situation a poster over on EliteTrader has gotten himself into. What reminded me was the confluence of Wallstrip's latest topic, i.e. Nike (NKE) and Adams post on vega which I posted about below.

Here is what a trader did on the 20th Dec as reported in ET:

Just bought NKE Jan 100 straddle for debit of 5.82. Option prices seem relatively cheep (sic) considering its right before earnings announcement. Any ideas on how it might play out? All comments are welcome!

To which one of the experienced hands replied:

Learning exercise.

Go to www.ivolatility.com and enter NKE in the ticker symbol location. Then look at the chart for historical IMPLIED VOLATILITY. Then compare where the IV is today for NKE compared to where it has been a few weeks ago.

To cut to the chase, current IV is at 25% or so. Last month it was at 16%. The high for the year is 28% last December (presumably before earnings) and the low is just under 16%.

So you are buying a straddle when IV is near historical highs.

In December of last year, IV crashed from its high of 28% or so to about 18%.

So what does this all mean. High IV means premiums are higher in value relatively. When earnings are released IV crushes. So your straddle will most likely go from an IV of 25% to somewhere below 20%. If you are not sure what that means, plug your straddle in an option calculator and change the IV from 25% to 19% and see what happens to the value of your straddle. It will drop sharply.

So before putting any money into a straddle you should study volatility and the effect it has on option prices.

Basically with respect to volatility you are buying high and gonna sell low after the news. So you need a real nice stock move to overcome the volatility crush AND time decay that will start creeping in...

...and that is exactly how it played out.

The poor guy bought the straddle on the 20th for $5.82 with the underlying at ~$100.00. Today with the underlying still ~$100.00 the straddle is worth about $3.60.

What happened? Implied volatility crush; which often happens once earnings are released... and if the stock doesn't move, or it doesn't move *enough, the trader gets smacked on long gamma positions (bought option positions like straddles).

This is what is termed "vega risk", the possibility that implied volatility will drop on your bought options (or rise on your short options) and cost you money, independent of any stock price movement.

The flip side of the coin is that it can also work in your favour. The trick is in understanding it as a risk when entering positions.