There are two primary advantages to spread trades, the first of which is that spread trading allows us to reduce the cost of the trade, thereby reducing the risk. For example, suppose stock XYZ is currently trading at $60, and you want to establish a bullish position. Assessing the current option quotes, you see that the one month 60 call is trading at $6 and the 70 call is trading at $2. Rather than buying the 60 calls outright for $6, we could enter a call spread by buying the 60 call and simultaneously selling the 70 call. This would drop our cost (and max risk) from $6 to $4.

A second advantage of spreads is the ability to place multi-directional trades. In other words, it is possible to create spreads that profit if the underlying stock moves up or down, up or sideways, down or sideways, etc. This allows us to widen the range of profitability, thereby increasing the probability of success. Becoming more comfortable with options spreads necessitates the use of risk graphs. Risk graphs visually portray the risk/reward characteristics of an options trade while also allowing the user to examine “what if” scenarios to see the effects that a change in time or volatility would have on a specific strategy.

Q: What is the difference between an American-style and a European-style option?

The main difference between these two styles of options is when they can be exercised. Most option traders, whether they’re aware of it or not, are trading American-style options. If you’ve ever traded options on stocks such as Wal-mart (WMT), Exxon (XOM), or Microsoft (MSFT), you’ve traded American-style options. These options can be exercised anytime prior to expiration. For example, if I were to buy a 3-month, 50-strike call on stock XYZ, I have the right to buy 100 shares of XYZ at $50. I can exercise this right today, tomorrow, or anytime before options expiration. European-style options are much less common, and can only be exercised on the day of expiration. A lot of stock indexes, like the NASDAQ 100 Index (NDX), Russell 2000 Index (RUT), or S&P 500 Index (SPX) are European style. It may be important to mention that, although we can’t exercise a European style options prior to expiration, we can sell it whenever we want. In addition, American and European options have nothing to do with geographic location.

Q: I tried my first straddle trade, and it left me quite perplexed. I placed the straddle two days before a stock’s earnings announcement, and when the announcement came out the stock gapped down eight percent. Although I expected to see a tidy profit, I was losing money! I thought a straddle makes money either way a stock moves?! What gives?

Your explanation reminds me of the first few straddles I tried back in the day! Rest assured you are not the first trader that has experienced the disappointment of unfulfilled expectations with straddles. Let’s see if I can shed some additional light on your trade. A straddle involves the simultaneous purchase of an at-the-money call option and a put option. Because the trader is long both a call and put option, the trade is bi-directional, and will profit if the stock makes a substantial move to the up or downside, as you stated in your question. However, there is another variable that can drastically affect the outcome of a straddle trade: implied volatility. Remember, as implied volatility rises, option premiums rise; as implied volatility falls, option premiums fall. In addition, at-the-money options are the most sensitive to changes in implied volatility. Because straddles involve the purchase of two at-the-money options, they are very sensitive to changes in implied volatility. In general, we like to enter straddles when implied volatility is low, and exit when implied volatility is high.

It is well known that earnings announcements generally cause an increase in volatility in the stock price, thus producing up-gaps and down-gaps. In anticipation of this increased stock volatility, option premiums (implied volatility) generally rise prior to the earnings announcement. Think of the earnings announcement as a catalyst to cause a short-term increase in actual stock volatility. Once the announcement has been made and the stock has reacted, the stock typically reverts back to its normal level of volatility. Consequently, after an earnings announcement is released, implied volatility usually gets crushed back down from its lofty, pre-earnings-announcement levels. This volatility crush causes the extrinsic value portion of an options premium to deflate very rapidly.

This could be what happened with your straddle trade. Although the gap down resulted in a theoretical gain due to the stock movement (Delta), you lost more money due to the volatility crush (Vega) that so often occurs after the earnings announcement. One possible solution for mitigating this volatility risk is to make sure that you enter the straddle before the implied volatility has increased too much. You can consult a volatility chart to determine whether or not the implied volatility has begun to increase. Sometimes, this may require you to enter approximately three to four weeks prior to the earnings announcement. In addition, if the implied volatility has increased substantially prior to the actual announcement, it may be wise to exit the straddle before the announcement and ensuing volatility crush. Good Luck!