ALWAYS BE READING AND LEARNING. YOU MIGHT GET A NEW TRADE IDEA.

• Posted by chicagosean
• on August 24th, 2010

 I’m currently reading “Inside the House of Money,” by Steven Drobny. I’m only about 70 pages in, but it has already planted the seed of a long-term trading strategy. The first interview subject of the book is Jim Leitner of Falcon Management in Wyckoff, NJ. He is what is considered a “Global Macro” trader who searches high and low for trading opportunities in any asset class in any country in the world. His inputs are virtually limitless.

One idea that was briefly touched upon in his interview was the idea of playing long-dated options, particularly long straddles. He makes the argument that most people are scared away from purchasing long-dated options because of the perception that they might be paying too much for volatility. He makes the case that volatility shouldn’t even factor into the thought process because when you’re playing long-dated options (he means a year or longer), you put yourself in position to catch an eventual good directional trend.

One strategy his firm employs (among many) is to purchase at-the-money straddles weekly that have at least a year until expiration. He does it weekly so as to spread the risk out evenly throughout the year. And I believe he typically only does this in currencies – but I may be wrong.

This got me thinking: What if at regular intervals (say weekly or monthly) one did a similar thing with equity options? You could do a weekly scan of S&P 500 companies and narrow down the search to stocks that are trading near the low end of their implied volatility for the past 12 months. Pick one and put on an ATM straddle in a strike at least a year until expiration.

For example, I just randomly decided to pull up $GE. The stock closed today at $14.57. I didn’t do a volatility screen, so I have no idea where that is. But for these illustrative purposes, please ignore it. One can purchase the January 2012 $15 straddle for $5.02. This trade would give me expiration breakevens at $9.98 on the downside and 20.03 on the upside (click the chart below if you need to see it bigger).

In 17 months, is it feasible that GE will move up or down $5? I’d like to think so. And according to the chart, the probability of GE touching my downside breakeven is 57% and my upside breakeven is 42%. That adds up to a 99% chance of one of these prices being touched!! If you simply exited the position when either of these points are breached instead of greedily holding until expiration, you would be nearly assured a profit (how much depends on WHEN the touch happens).

This is the extent of my research into this idea – all of about 5 minutes. I’m sure there are some things I’m not considering. But this is a great starting point for a trading idea.

All this from reading only the first interview in a book packed with interviews. If each one yields just one trading idea, the time spent reading “Inside the House of Money” will be well worth the investment. We’re off to a great start.

Keep reading and never stop learning!

(PS…if you’re interested in purchasing this book, so you can click the image above. I’ll earn a small commission) ;)

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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