Straddle Strategies in Option Trading

Straddle Strategies in Option Trading

The straddle strategy is an option strategy that's based on buying both a call and put of a stock. Note that there are various forms of straddles, but we will only be covering the basic straddle strategy. To initiate a Straddle, we would buy a Call and Put of a stock with the same expiration date and strike price. For example, we would initiate a Straddle for company ABC by buying a June 200 Call as well as a June 200 Put.

Now why would we want to buy both a Call and a Put? Calls are for when you expect the stock to go up, and Puts are for when you expect the stock to go down, right?

In an ideal world, we would like to be able to clearly predict the direction of a stock. However, in the real world, it's quite difficult. On the other hand, it's relatively easier to predict whether a stock is going to move (without knowing whether the move is up or down). One method of predicting volatility is by using the Technical Indicator called Bollinger Bands.

For example, you know that ABC's annual report is coming out this week, but do not know whether they will exceed expectations or not. You could assume that the stock price will be quite volatile, but since you don't know the news in the annual report, you wouldn't have a clue which direction the stock will move. In cases like this, a Straddle strategy would be good to adopt.

If the price of the stock shoots up, your Call will be way In-The-Money, and your Put will be worthless. If the price plummets, your Put will be way In-The-Money, and your Call will be worthless. This is safer than buying either just a Call or just a Put. If you just bought a one-sided option, and the price goes the wrong way, you're looking at possibly losing your entire premium investment. In the case of Straddles, you will be safe either way, though you are spending more initially since you have to pay the premiums of both the Call and the Put.

If Straddles are so good, why doesn't everybody use them for every investment?

It fails when the stock price doesn't move. If the price of the stock hovers around the initial price, both the Call and the Put will not be that much In-The-Money. Furthermore, the closer it is to the expiration date, the cheaper premiums are. Option premiums have a Time Value associated with them. So an option expiring this month will have a cheaper premium than an option with the same strike price expiring next year.

So in the case where the stock price doesn't move, the premiums of both the Call and Put will slowly decay, and we could end up losing a large percentage of our investment. The bottom line is: for a Straddle strategy to be profitable, there has to be volatility, and a marked movement in the stock price.

A more advanced investor can tweak Straddles to create many variations. They can buy different amounts of Calls and Puts with different Strike Prices or Expiration Dates, modifying the Straddles to suit their individual strategies and risk tolerance.

Very nice writeup,Neal.......thanks!

yep,ditto that!!

Dear Neal,
That was a very nice write up of the straddle, however i would just like to add that it is very important to know your breakeven point before hand.
there are two break evens in a straddle
upside breakeven : strike price + net debit paid
down side breakeven : strike price - net debit paid

the time decay accelerates as the options approach expiration and normally this strategy is liquidated before expiration.

the profit in this stragety is unlimited and the loss is limited to the premium paid.
but always remember the time decay effect is against you, so suggest expiration of more than 2 months.

rqt pl correct me
b rgds
Gopii

If your scenario is correct- if their is a hint that there is market moving news- you can bet that the Volatilities will be inflated- which basically increases the cost of the straddle- and hence increases your breakeven point.

You cannot make money if IV levels are high- if you gain on one side- after the news the IV settles down, and sucks out the "premium" and you will end up losing money most of the time.

Bottomline- do watch IV levels and where they stand with respect to Historical volatility, That is the first thing you need to look at when you trade options anyway!

thank you very much for the straddle info.

Regards,

Formose