The Straddle Trading Strategy

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Long straddle

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To profit from a big price change – either up or down – in the underlying stock.

Explanation

Example of long straddle

Buy 1 XYZ 100 call at (3.30)
Buy 1 XYZ 100 put at (3.20)
Net cost = (6.50)

A long straddle consists of one long call and one long put. Both options have the same underlying stock, the same strike price and the same expiration date. A long straddle is established for a net debit (or net cost) and profits if the underlying stock rises above the upper break-even point or falls below the lower break-even point. Profit potential is unlimited on the upside and substantial on the downside. Potential loss is limited to the total cost of the straddle plus commissions.

Maximum profit

Profit potential is unlimited on the upside, because the stock price can rise indefinitely. On the downside, profit potential is substantial, because the stock price can fall to zero.

Maximum risk

Potential loss is limited to the total cost of the straddle plus commissions, and a loss of this amount is realized if the position is held to expiration and both options expire worthless. Both options will expire worthless if the stock price is exactly equal to the strike price at expiration.

Breakeven stock price at expiration

There are two potential break-even points:

  1. Strike price plus total premium:
    In this example: 100.00 + 6.50 = 106.50
  2. Strike price minus total premium:
    In this example: 100.00 – 6.50 = 93.50

Profit/Loss diagram and table: long straddle

Long 1 100 call at (3.30)
Long 1 100 put at (3.20)
Net cost = (6.50)
Stock Price at Expiration Long 100 Call Profit/(Loss) at Expiration Long 100 Put Profit/(Loss) at Expiration Long Straddle Profit / (Loss) at Expiration
110 +6.70 (3.20) +3.50
109 +5.70 (3.20) +2.50
108 +4.70 (3.20) +1.50
107 +3.70 (3.20) +0.50
106 +2.70 (3.20) (0.50)
105 +1.70 (3.20) (1.50)
104 +0.70 (3.20) (2.50)
103 (0.30) (3.20) (3.50)
102 (1.30) (3.20) (4.50)
101 (2.30) (3.20) (5.50)
100 (3.30) (3.20) (6.50)
99 (3.30) (2.20) (5.50)
98 (3.30) (1.20) (4.50)
97 (3.30) (0.20) (3.50)
96 (3.30) +0.80 (2.50)
95 (3.30) +1.80 (1.50)
94 (3.30) +2.80 (0.50)
93 (3.30) +3.80 +0.50
92 (3.30) +4.80 +1.50
91 (3.30) +5.80 +2.50
90 (3.30) +6.80 +3.50

Appropriate market forecast

A long straddle profits when the price of the underlying stock rises above the upper breakeven point or falls below the lower breakeven point. The ideal forecast, therefore, is for a “big stock price change when the direction of the change could be either up or down.” In the language of options, this is known as “high volatility.”

Strategy discussion

A long – or purchased – straddle is the strategy of choice when the forecast is for a big stock price change but the direction of the change is uncertain. Straddles are often purchased before earnings reports, before new product introductions and before FDA announcements. These are typical of situations in which “good news” could send a stock price sharply higher, or “bad news” could send a stock price sharply lower. The risk is that the announcement does not cause a significant change in stock price and, as a result, both the call price and put price decrease as traders sell both options.

It is important to remember that the prices of calls and puts – and therefore the prices of straddles – contain the consensus opinion of options market participants as to how much the stock price will move prior to expiration. This means that buyers of straddles believe that the market consensus is “too low” and that the stock price will move beyond a breakeven point – either up or down.

The same logic applies to options prices before earnings reports and other such announcements. Dates of announcements of important information are generally publicized in advanced and well-known in the marketplace. Furthermore, such announcements are likely, but not guaranteed, to cause the stock price to change dramatically. As a result, prices of calls, puts and straddles frequently rise prior to such announcements. In the language of options, this is known as an “increase in implied volatility.”

An increase in implied volatility increases the risk of trading options. Buyers of options have to pay higher prices and therefore risk more. For buyers of straddles, higher options prices mean that breakeven points are farther apart and that the underlying stock price has to move further to achieve breakeven. Sellers of straddles also face increased risk, because higher volatility means that there is a greater probability of a big stock price change and, therefore, a greater probability that an option seller will incur a loss.

“Buying a straddle” is intuitively appealing, because “you can make money if the stock price moves up or down.” The reality is that the market is often “efficient,” which means that prices of straddles frequently are an accurate gauge of how much a stock price is likely to move prior to expiration. This means that buying a straddle, like all trading decisions, is subjective and requires good timing for both the buy decision and the sell decision.

Impact of stock price change

When the stock price is at or near the strike price of the straddle, the positive delta of the call and negative delta of the put very nearly offset each other. Thus, for small changes in stock price near the strike price, the price of a straddle does not change very much. This means that a straddle has a “near-zero delta.” Delta estimates how much an option price will change as the stock price changes.

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However, if the stock price “rises fast enough” or “falls fast enough,” then the straddle rises in price. This happens because, as the stock price rises, the call rises in price more than the put falls in price. Also, as the stock price falls, the put rises in price more than the call falls. In the language of options, this is known as “positive gamma.” Gamma estimates how much the delta of a position changes as the stock price changes. Positive gamma means that the delta of a position changes in the same direction as the change in price of the underlying stock. As the stock price rises, the net delta of a straddle becomes more and more positive, because the delta of the long call becomes more and more positive and the delta of the put goes to zero. Similarly, as the stock price falls, the net delta of a straddle becomes more and more negative, because the delta of the long put becomes more and more negative and the delta of the call goes to zero.

Impact of change in volatility

Volatility is a measure of how much a stock price fluctuates in percentage terms, and volatility is a factor in option prices. As volatility rises, option prices – and straddle prices – tend to rise if other factors such as stock price and time to expiration remain constant. Therefore, when volatility increases, long straddles increase in price and make money. When volatility falls, long straddles decrease in price and lose money. In the language of options, this is known as “positive vega.” Vega estimates how much an option price changes as the level of volatility changes and other factors are unchanged, and positive vega means that a position profits when volatility rises and loses when volatility falls.

Impact of time

The time value portion of an option’s total price decreases as expiration approaches. This is known as time erosion, or time decay. Since long straddles consist of two long options, the sensitivity to time erosion is higher than for single-option positions. Long straddles tend to lose money rapidly as time passes and the stock price does not change.

Risk of early assignment

Owners of options have control over when an option is exercised. Since a long straddle consists of one long, or owned, call and one long put, there is no risk of early assignment.

Potential position created at expiration

There are three possible outcomes at expiration. The stock price can be at the strike price of a long straddle, above it or below it.

If the stock price is at the strike price of a long straddle at expiration, then both the call and the put expire worthless and no stock position is created.

If the stock price is above the strike price at expiration, the put expires worthless, the long call is exercised, stock is purchased at the strike price and a long stock position is created. If a long stock position is not wanted, the call must be sold prior to expiration.

If the stock price is below the strike price at expiration, the call expires worthless, the long put is exercised, stock is sold at the strike price and a short stock position is created. If a short stock position is not wanted, the put must be sold prior to expiration.

Note: options are automatically exercised at expiration if they are one cent ($0.01) in the money. Therefore, if the stock price is “close” to the strike price as expiration approaches, and if the owner of a straddle wants to avoid having a stock position, the long straddle must be sold prior to expiration.

Other considerations

Long straddles are often compared to long strangles, and traders frequently debate which the “better” strategy is.

Long straddles involve buying a call and put with the same strike price. For example, buy a 100 Call and buy a 100 Put. Long strangles, however, involve buying a call with a higher strike price and buying a put with a lower strike price. For example, buy a 105 Call and buy a 95 Put.

Neither strategy is “better” in an absolute sense. There are tradeoffs.

There are three advantages and two disadvantages of a long straddle. The first advantage is that the breakeven points are closer together for a straddle than for a comparable strangle. Second, there is less of a change of losing 100% of the cost of a straddle if it is held to expiration. Third, long straddles are less sensitive to time decay than long strangles. Thus, when there is little or no stock price movement, a long straddle will experience a lower percentage loss over a given time period than a comparable strangle. The first disadvantage of a long straddle is that the cost and maximum risk of one straddle (one call and one put) are greater than for one strangle. Second, for a given amount of capital, fewer straddles can be purchased.

The long strangle two advantages and three disadvantages. The first advantage is that the cost and maximum risk of one strangle are lower than for one straddle. Second, for a given amount of capital, more strangles can be purchased. The first disadvantage is that the breakeven points for a strangle are further apart than for a comparable straddle. Second, there is a greater chance of losing 100% of the cost of a strangle if it is held to expiration. Third, long strangles are more sensitive to time decay than long straddles. Thus, when there is little or no stock price movement, a long strangle will experience a greater percentage loss over a given time period than a comparable straddle.

Straddle

What is Straddle?

A straddle strategy is a strategy that involves simultaneously taking a long position and a short position on a security. Consider the following example: A trader buys and sells a call option Call Option A call option, commonly referred to as a “call,” is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock or other financial instrument at a specific price – the strike price of the option – within a specified time frame. and put option Put Option A put option is an option contract that gives the buyer the right, but not the obligation, to sell the underlying security at a specified price (also known as strike price) before or at a predetermined expiration date. It is one of the two main types of options, the other type being a call option. at the same time for the same underlying asset at a certain point of time. Both options have the exact same expiry date and strike price.

The straddle strategy is usually used by a trader when they are not sure which way the price will move. The trades in different directions can compensate for each other’s losses.

In a straddle trade, the trader can either long (buy) both options (call and put) or short (sell) both options. The result of such a strategy depends on the eventual price movement of the associated stock. The level of price movement, and not the direction of the price, affects the result of a straddle.

Requirements for a Straddle Trade

A trade is considered a straddle if it meets the following requirements:

  • The trader can either buy or sell call or put options
  • The options should be part of the same security
  • The strike price Strike Price The strike price is the price at which the holder of the option can exercise the option to buy or sell an underlying security, depending on whether they hold a call option or put option. An option is a contract with the right to exercise the contract at a specific price, which is known as the strike price. should be the same for both trades
  • The expiry date for the options should be the same

When to Use the Straddle Options Strategy?

The straddle options strategy can be used in two situations:

1. Directional play

This is when there is a dynamic market and high price fluctuations, which results in a lot of uncertainty for the trader. When the price of the stock can go up or down, the straddle strategy is used. It is also known as implied volatility.

2. Volatility play

When there is an event in the economy such as an earnings announcement Earnings Guidance An earnings guidance is the information provided by the management of a publicly traded company regarding its expected future results, including estimates of revenues, expenses, margins, and earnings. or the release of the annual budget, the volatility in the market increases before the announcement is made. The traders usually buy stocks in companies that are about to make earnings.

Sometimes, many traders use the straddle strategy too soon, which can increase the ATM call and ATM put options and make them very expensive to buy. Traders need to be assertive and exit the market before such a situation arises.

Example of a Straddle Option

The straddle option is used when there is high volatility in the market and uncertainty in the price movement. It would be optimal to use the straddle when there is an option with a long time to expiry. The trader should also ensure that the option is at the money, meaning that the strike price should be the same as the underlying asset’s price.

The trader enjoys an advantage when the values of the call or put are greater than or lesser than when the strategy was first implemented. It can help counterbalance the cost of trading the asset, and any money left behind is considered a profit.

Suppose Apple’s stock is trading at $60, and the trader decides to start a long straddle by buying the call option and the put option at the strike price of $120. The call costs $25 while the put costs $21. The total cost to the trader is $46 (25 + 21).

If the trader strategy fails, his maximum loss will be $46. At the expiry date, the Apple stock trades at $210, therefore the put option expires immediately as it is out of the money, but the call option is in the money (the strike price is below the trading price), and when the option expires, the revenue earned on the option will be $90 (210 – 120). The initial cost to the trader of $46 is further subtracted from this leaving the trader with a profit of $44 (90 – 46).

Suppose the trader exits the market before the expiry date and the Apple stock trades at the strike price of $120. The call option is at $10 while the put option is at $25, the payout will be as follows:

Call: ($10 – $25) = –$15 loss

Put: ($25 – $21) = $4 profit

The net loss is –$11.

Long straddle

In a long straddle, the trader buys both the call and put options. The expiry date and strike price for the options must be the same. It is recommended to buy the option when the stock is undervalued or discounted, regardless of how the stock moves. It is considered a low risk trade for investors because, as shown in the example, the cost of purchasing the call and put options is the maximum amount of loss the trader will face.

Short straddle

A short straddle is the opposite of a long straddle and happens when the trader sells both call and put options with the same strike price and date of expiry. It is best to sell the call and put options when the stock is overvalued, regardless of how the stock moves. It is risky for the investor as they could lose the total value of the stock for both the options and the profit earned is limited to the premium on both options.

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Chandelier Exit Chandelier Exit Chandelier Exit (CE) is a volatility-based indicator that identifies stop loss exit points for long and short trading positions. Chuck Le Beau, a recognized expert in exit strategies, developed the CE indicator. However, Alexander Elder introduced the strategy to traders
  • Long and Short Positions Long and Short Positions In investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short).
  • Stop Loss Order Stop-Loss Order A stop-loss order is a tool used by traders and investors to limit losses and reduce risk exposure. With a stop-loss order, an investor enters an order to exit a trading position that he holds if the price of his investment moves to certain level that represents a specified amount of loss
  • Trade Order Timing Trade Order Timing – Trading Trade order timing refers to the shelf-life of a specific trade order. The most common types of trade order timing are market orders, GTC orders, and fill or kill orders.

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Key Concepts Options Strategies

Straddle

A short straddle is a position that is a neutral strategy that profits from the passage of time and any decreases in implied volatility. The short straddle is an undefined risk option strategy.

Directional Assumption: Neutral

Setup:
– Sell ATM Call
– Sell ATM Put

Ideal Implied Volatility Environment : High

Max Profit: Credit received from opening trade

How to Calculate Breakeven(s):
– Downside: Subtract initial credit from Put strike price
– Upside: Add initial credit to the Call strike price

With straddles, it is important to remember that we are working with truly undefined risk in selling a naked call. We focus on probabilities at trade entry, and make sure to keep our risk / reward relationship at a reasonable level.

Implied volatility (IV) plays a huge role in our strike selection with straddles. The higher the IV, the more credit we will receive from selling the options. A higher credit ultimately means we will have wider breakeven points, since we can use the credit to offset losses we may see to the upside or downside. At the end of the day, a larger relative credit results in a higher probability of success with this strategy.

Our target timeframe for selling straddles is around 45 days to expiration. Our studies show this is a great balance between shorter and longer timeframes.

When do we close straddles?
The first profit target is generally 25% of the maximum profit. This is done by buying the straddle back for 75% of the credit received at order entry.

When do we defend straddles?
With premium selling strategies, defensive tactics revolve around collecting more premium to improve our break-even price, and further reduce our cost basis. With short straddles, we don’t have much wiggle room because the short options are already on the same strikes. One option is to roll the whole straddle out in time, using the same strikes. This can be done for a credit, and we will hope for the stock price to return to our short strike by the new expiration.

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