The Straddle Trading Strategy

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Straddle

What Is a Straddle?

A straddle is a neutral options strategy that involves simultaneously buying both a put option and a call option for the underlying security with the same strike price and the same expiration date.

A trader will profit from a long straddle when the price of the security rises or falls from the strike price by an amount more than the total cost of the premium paid. Profit potential is virtually unlimited, so long as the price of the underlying security moves very sharply.

Key Takeaways

  • A straddle is an options strategy involving the purchase of both a put and call option for the same expiration date and strike price on the same underlying.
  • The strategy is profitable only when the stock either rises or falls from the strike price by more than the total premium paid.
  • A straddle implies what the expected volatility and trading range of a security may be by the expiration date.

Straddles Academy

Understanding Straddles

More broadly, straddle strategies in finance refer to two separate transactions which both involve the same underlying security, with the two component transactions offsetting one another. Investors tend to employ a straddle when they anticipate a significant move in a stock’s price but are unsure about whether the price will move up or down.

A straddle can give a trader two significant clues about what the options market thinks about a stock. First is the volatility the market is expecting from the security. Second is the expected trading range of the stock by the expiration date.

Putting Together a Straddle

To determine the cost of creating a straddle one must add the price of the put and the call together. For example, if a trader believes that a stock may rise or fall from its current price of $55 following earnings on March 1, they could create a straddle. The trader would look to purchase one put and one call at the $55 strike with an expiration date of March 15. To determine the cost of creating the straddle, the trader would add the price of one March 15 $55 call and one March 15 $55 put. If both the calls and the puts trade for $2.50 each, the total outlay or premium paid would be $5.00 for the two contracts.

The premium paid suggests that the stock would need to rise or fall by 9% from the $55 strike price to earn a profit by March 15. The amount the stock is expected to rise-or-fall is a measure of the future expected volatility of the stock. To determine how much the stock needs to rise or fall, divide the premium paid by the strike price, which is $5 / $55, or 9%.

Discovering the Predicted Trading Range

Option prices imply a predicted trading range. To determine the expected trading range of a stock, one could add or subtract the price of the straddle to or from the price of the stock. In this case, the $5 premium could be added to $55 to predict a trading range of $50 to $60. If the stock traded within the zone of $50 to $60, the trader would lose some of their money but not necessarily all of it. At the time of expiration, it is only possible to earn a profit if the stock rises or falls outside of the $50 to $60 zone.

Earning a Profit

If the stock fell to $48, the calls would be worth $0, while the puts would be worth $7 at expiration. That would deliver a profit of $2 to the trader. However, if the stock went to $57, the calls would be worth $2, and the puts would be worth zero, giving the trader a loss of $3. The worst-case scenario is when the stock price stays at or near the strike price.

Real World Example

On October 18, 2020, the options market was implying that AMD’s stock could rise or fall 20% from the $26 strike price for expiration on November 16, because it cost $5.10 to buy one put and call. It placed the stock in a trading range of $20.90 to $31.15. A week later, the company reported results and shares plunged from $22.70 to $19.27 on October 25. In this case, the trader would have earned a profit because the stock fell outside of the range, exceeding the premium cost of buying the puts and calls.

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Understanding Straddle Strategy For Market Profits

In trading, there are numerous sophisticated trading strategies designed to help traders succeed regardless of whether the market moves up or down. Some of the more sophisticated strategies, such as iron condors and iron butterflies, are legendary in the world of options. They require complex buying and selling of multiple options at various strike prices. The end result is to make sure a trader is able to profit no matter where the underlying price of the stock, currency or commodity ends up.

However, one of the least sophisticated option strategies can accomplish the same market neutral objective with a lot less hassle. The strategy is known as a straddle. It only requires the purchase or sale of one put and one call to become activated. In this article, we’ll take a look at different the types of straddles and the benefits and pitfalls of each.

Types of Straddles

A straddle is a strategy accomplished by holding an equal number of puts and calls with the same strike price and expiration dates. The following are the two types of straddle positions.

  • Long Straddle – The long straddle is designed around the purchase of a put and a call at the exact same strike price and expiration date. The long straddle is meant to take advantage of the market price change by exploiting increased volatility. Regardless of which direction the market’s price moves, a long straddle position will have you positioned to take advantage of it.
  • Short Straddle – The short straddle requires the trader to sell both a put and a call option at the same strike price and expiration date. By selling the options, a trader is able to collect the premium as a profit. A trader only thrives when a short straddle is in a market with little or no volatility. The opportunity to profit will be based 100% on the market’s lack of ability to move up or down. If the market develops a bias either way, then the total premium collected is at jeopardy.

The success or failure of any straddle is based on the natural limitations that options inherently have along with the market’s overall momentum. (For more, see: Option Basics Tutorial)

The Long Straddle

A long straddle is specially designed to assist a trader to catch profits no matter where the market decides to go. There are three directions a market may move: up, down or sideways. When the market is moving sideways, it’s difficult to know whether it will break to the upside or downside. To successfully prepare for the market’s breakout, there is one of two choices available:

  1. The trader can pick a side and hope the market breaks in that direction.
  2. The trader can hedge his or her bets and pick both sides simultaneously. That’s where the long straddle comes in.

By purchasing a put and a call, the trader is able to catch the market’s move regardless of its direction. If the market moves up, the call is there; if the market moves down, the put is there. In Figure 1, we look at a 17-day snapshot of the euro market. This snapshot finds the euro stuck between $1.5660 and $1.54.

While the market looks like it may break through the $1.5660 price, there is no guarantee it will. Based on this uncertainty, purchasing a straddle will allow us to catch the market if it breaks to the upside or if it heads back down to the $1.54 level. This allows the trader to avoid any surprises.

Drawbacks to the Long Straddle

The following are the three key drawbacks to the long straddle.

  • Expense
  • Risk of loss
  • Lack of volatility

The rule of thumb when it comes to purchasing options is in-the-money and at-the-money options are more expensive than out-of-the-money options. Each at-the-money option can be worth a few thousand dollars. So while the original intent is to be able to catch the market’s move, the cost to do so may not match the amount at risk.

In Figure 2 we see the market breaks to the upside, straight through $1.5660.

ATM Straddle (At-The-Money)

This leads us to the second problem: risk of loss. While our call at $1.5660 has now moved in the money and increased in value in the process, the $1.5660 put has now decreased in value because it has now moved farther out of the money. How quickly a trader can exit the losing side of straddle will have a significant impact on what the overall profitable outcome of the straddle can be. If the option losses mount quicker than the option gains or the market fails to move enough to make up for the losses, the overall trade will be a loser.

The final drawback deals with the inherent makeup of options. All options are comprised of the following two values:

  • Time value – The time value comes from how far the option is from expiring. (For more insight, read: The Importance Of Time Value.)
  • Intrinsic value – The intrinsic value comes from the option’s strike price being out, in, or at the money.

If the market lacks volatility and does not move up or down, both the put and call option will lose value every day. This will go on until the market either definitively chooses a direction or the options expire worthless.

The Short Straddle

The short straddle’s strength is also its drawback. Instead of purchasing a put and a call, a put and a call are sold in order to generate income from the premiums. The thousands spent by the put and call buyers actually fill your account. This can be a great boon for any trader. The downside, however, is that when you sell an option you expose yourself to unlimited risk. (For related reading, see: Options Hazards That Can Bruise Your Portfolio.)

As long as the market does not move up or down in price, the short straddle trader is perfectly fine. The optimum profitable scenario involves the erosion of both the time value and the intrinsic value of the put and call options. In the event the market does pick a direction, the trader not only has to pay for any losses that accrue, but he or she must also give back the premium he has collected.

The only recourse short straddle traders have is to buy back the options they sold when the value justifies doing so. This can occur anytime during the life cycle of a trade. If this is not done, the only choice is to hold on until expiration.

When Straddles Strategy Works Best

The option straddle works best when it meets at least one of these three criteria:

  • The market is in a sideways pattern.
  • There is pending news, earnings or another announcement.
  • Analysts have extensive predictions on a particular announcement.

Analysts can have tremendous impact on how the market reacts before an announcement is ever made. Prior to any earnings decision or governmental announcement, analysts do their best to predict what the exact value of the announcement will be. Analysts may make estimates weeks in advance of the actual announcement, which inadvertently forces the market to move up or down. Whether the prediction is right or wrong is secondary to how the market reacts and whether your straddle will be profitable. (For more insight, read Analyst Recommendations: Do Sell Ratings Exist?)

After the actual numbers are released, the market has one of two ways to react: The analysts’ prediction can add either to or decrease the momentum of the actual price once the announcement is made. In other words, it will proceed in the direction of what the analyst predicted or it will show signs of fatigue. A properly created straddle, short or long, can successfully take advantage of just this type of market scenario. The difficulty occurs in knowing when to use a short or a long straddle. This can only be determined when the market will move counter to the news and when the news will simply add to the momentum of the market’s direction.

Conclusion

There is a constant pressure on traders to choose to buy or sell, collect premium or pay premiums, but the straddle is the great equalizer. The straddle allows a trader to let the market decide where it wants to go. The classic trading adage is “the trend is your friend.” Take advantage of one of the few times you are allowed to be in two places at once with both a put and a call. (For related reading, see: How the Straddle Rule Creates Tax Opportunities for Options Traders.)

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