Straddles
A straddle is a spread consisting of a put and a call, either both long or both short, with the same strike price and expiration. If the strike price is much different from the current price of the underlying, one of the two options will be very in-the-money (ITM) and the other will be very out-of-the-money (OOTM). The very ITM option will behave almost like the underlying (i.e., have a delta that is near +1 or -1) and the very OOTM option will have a very low delta and therefore will not be very responsive to movement in the underlying.
For this reason, the strike price of most straddles taken by traders is close to the price of the underlying. In this case, the call and the put will have delta near 1/2 and -1/2, so the straddle will be more or less delta neutral.
Because puts and calls with the same strike price and expiration almost always have implied volatilities that are nearly identical (see earlier commentaries for an explanation of this), if one of the two is underpriced, the other probably will be underpriced as well. Purchasing such a straddle will give you two edges, one for the call and one for the put.
Likewise, if a call is overpriced, its corresponding put will likely also be overpriced, and selling such a straddle will again give you two edges. (Note however that a long straddle’s risk is limited to the combined cost of the call and the put, and unlimited profit potential, while a short straddle has profit potential limited to the total premium collected from the sale of the call and the put, and unlimited risk).
To look for good straddles to purchase, locate either an underpriced call or an underpriced put with strike price near the price of the underlying from one of the underpriced lists, and then add its mate to it. Try this yourself–I will show some examples on Thursday.