How to Trade Big Up or Down Moves with Straddles
A straddle is an options strategy in which the trader buys both a call and a put at the same strike price with the same expiration month. Differences in the costs of calls and puts will likely mean that the trader will not have the equal number of calls and puts, but the dollar amount must be virtually identical for the straddle to work as intended.
A trader chooses an options straddle when he or she does not have a clear sense of which direction a given stock will move, but has a strong opinion that the stock’s volatility or movement will increase before the options expire.
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The straddle is put on, and then as the trade begins to move in one of the two possible directions, the trader sells the other, losing end of the straddle and lets the winning end of the straddle continue to appreciate.
The goal is for the underlying stock to move far enough that the winning leg of the position makes more money than the losing leg of the position costs. If the underlying stock does not move, or moves very little before expiration, then the straddle holder will lose money.
Here is a P&L chart of an option straddle. The vertical axis represents the profit or loss. The horizontal axis represents the price of the underlying stock.
Note how when the price of the underlying stock is far from the strike, either far below the strike price or far above it, the straddle is at its most profitable. This means that one leg of the trade the call end if the stock moved higher, the put end if the stock moved lower made more than was lost by the other leg of the trade.
At the same time, the straddle is at its least profitable when the underlying stock is at the strike price. Here, both the call, which bet on a higher price, and the put, which bet on a lower price, are losers.
This is an example of the most common options straddle, the long straddle in which a call and a put of the same strike price and expiration date are purchased. This strategy is typically used when traders believe a significant price move is imminent, but is uncertain about direction. Earnings season often provides traders with opportunities to use straddles, as do certain technical patterns.
On the other hand, when traders believe that a major decrease in volatility is coming, they can use a short straddle strategy. The short straddle strategyis the exact opposite of the long straddle, and involves selling both a call and a put with the same strike price and expiration date. Here, as long as the underlying stock does not move much before expiration, the short straddle seller or “writer” will gain.
In terms of risk, straddle trading is considered moderate. This is because the amount of risk is determined at the beginning when the trader buys the options. In a long straddle trade, the options buyer can only lose as much as he or she paid for the options. With regard to the reward for the successful long straddle trader, the upside potential is significant because even if the losing end of the straddle goes to zero, the winning end can continue rising and making money for the trader until the expiration date arrives or a profit target is reached.
David Penn is Senior Editor at TradingMarkets.com.
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