Straddle Strategies in Option Trading

Comments (20)


Straddle Strategies in Option Trading

By: Steven T. Ng

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 $20 Call as well as a June $20 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.

Let's look at a numerical example:

For stock XYZ, let's imagine the share price is now sitting at $63.) There is news that a legal suit against XYZ will conclude tomorrow. No matter the result of the suit, you know that there will be volatility. If they win, the price will jump. If they lose, the price will plummet.

So we decide to initiate a Straddle strategy on the XYZ stock. We decide to buy a $65 Call and a $65 Put on XYZ, $65 being the closest strike price to the current stock price of $63.) The premium for the Call (which is $2 Out-Of-The-Money) is $0.75, and the premium for the Put (which is $2 In-The-Money) is $3.) 00. So our total initial investment is the sum of both premiums, which is $3.) 75.)

Fast forward 2 days. XYZ won the legal battle! Investors are more confident of the stock and the price jumps to $72.) The $65 Call is now $7 In-The-Money and its premium is now $8.) 00. The $65 Put is now Way-Out-Of-The-Money and its premium is now $0.25.) If we close out both positions and sell both options, we would cash in $8.) 00 + $0.25 = $8.) 25.) That's a profit of $4.) 50 on our initial $3.) 75 investment!

Of course, we could have just bought a basic Call option and earned a greater profit. But we didn't know which direction the stock price would go. If XYZ lost the legal battle, the price could have dropped $10, making our Call worthless and causing us to lose our entire investment. A Straddle strategy is more conservative and will profit whether the stock goes up or down.

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.

If you want to read more information on straddles and other option strategies, visit http://www.option-trading-guide.com/options_guide.html

About The Author

Steven is the webmaster of http://www.option-trading-guide.com If you would like to learn more about Option Trading or Technical Analysis, do visit for various strategies and resources to help your stock market investments.

webmaster@option-trading-guide.com

Comments

jackiesymon 03.05.2008. 19:44

What are the tax implications of options trading? If I use an option straddle strategy, and I bring in $100K over the course of the year but I lose $90K on the other side of the straddle, do I pay taxes on the $100K, or only on the $10K that I actually came away with? If I have to pay tax on the $100K, am I only allowed to deduct the max allowed loss of $3K?

Thanks!

jackiesymon

Admin 03.05.2008. 19:44

If these are the realized gain and losses (you actually sold and bought) that you've, you 10k will be your net gain. You got to remember to include the option that expired as part of the losses.

Just in case, you've got net losses at the of the year. You can only deduct up to $3,000 on your individual tax return per year.

Admin

evan 23.10.2012. 23:15

What is the iron condor options trading strategy? how do I do a iron condor options strategy. are my losses unlimited? I read up on iron condor strategies, but I just do not understand them. Can someone please explain them to me with an example. pS I Know what options are.

evan

Admin 23.10.2012. 23:15

I am often asked why I choose to use a 'reverse iron condor' strategy? This is a good question and I will try my best to explain why I may choose one over another.

The 'Reverse Iron Condor' Trade

There are some traders/authors out there who will tell you that it is not a good idea to use a 'reverse iron condor' trade on stocks that are below $100.00/share. While this is true in certain situations, I can assure you that you will be missing out on plenty of great trades if you stick to that formula.
The 'reverse iron condor' spread is a neutral options strategy. It is placed as a net debit, instead of a net credit. The most you can ever lose on this trade is your one-time investment at the beginning when placing this trade. So what is the general rule when making this decision? There are a few factors that come into play here. First, I personally prefer to use a 'reverse iron condor' trade on stocks that have weekly options available and that are reporting earnings that same week. This prerequisite does not apply if the stock is reporting earnings on the third week of the month, i.e. options expiration, which means any stock that has earnings that week would work if the stock is expected to see a significant, but not a major price move. Since this applies to only a select number of stocks , for only three out of four potential weeks, picking which ones to use is critical.

Reverse Iron Condor Construction

Buy 1 OTM Put

Sell 1 OTM Put (Lower Strike)

Buy 1 OTM Call

Sell 1 OTM Call (Higher Strike)

It should also be noted that your broker usually requires a Level 3 or Level 4 trading account to make this trade. If you do not have this level, you can always request an upgrade.

Advantages Using The 'Reverse Iron Condor' Strategy:

Much less total investment.

A debit spread (does not tie up capital).

A much smaller price move needed than a 'strange' or 'straddle' trade.

Knowing a set price-per-share needed ahead of time in order to profit.

Much less drama and nerves both before and after earnings are released.

Easy to manage.

Disadvantages Using The 'Reverse Iron Condor' Strategy:

Much less of a profit obtained in the event that the stock makes a major price move.

Four legs on the trade, which results in higher commission costs.

While you can profit ahead of an earnings release, the 'reverse iron condor' usually profits after the announcement is made. This is not always the case, however, but should be expected going into the trade.

You must choose this trade carefully.

Too much time left on the trade can be a detriment, as it could revert back to the middle strike prices, which is the worst-case scenario with this trade. (the same can be said about the 'strangle' or 'straddle' trade.


If you have any questions, please leave a comment or send me an e-mail DAVIDSDAVIS2003@YAHOO.COM. Thanks.

Admin

Bob W 28.08.2007. 07:16

What's your favorite options trading strategy, and why? How do you usually play the options market? Selling naked puts? Covered calls? Buying deep in the money calls? Spreads? Straddles? What strategy are you the most comfortable - and successful - with, and why?

Bob W

Admin 28.08.2007. 07:16

I'm a bit like The Shepherd. I've been selling a lot of naked calls & puts lately. I look for opportunities in low priced stocks ($35 or less). This minimizes the margin requirements. I seem to recall that most options expire worthless rather than being exercised.

Deep in the money calls can be good, depending on the stock.
A while back I used this to make some good money from Google.

If you're buying calls or puts, generally stick to months a ways out. A lot can happen in the short term to act against you, but if you have time, things can turn around.

Options require more attention in my opinion than stocks due to the volatility.

Remember the cardinal rule of options trading: Never commit more money than you can afford to LOSE!

Admin

BizAnswers 07.11.2006. 19:28

What is the best brokerage firm for sophisticated stock option trading strategies? It's not Scottrade, IMO. I would like to hear only from those who have actually used the brokerage for things like spreads, straddles, condors, etc.

Please explain why you think it is the best? Is it order entry, cost, reputation, support, etc.?
Had E*Trade once and would not go back.

BizAnswers

Admin 07.11.2006. 19:28

No, it's not scottrade. And it's definitely not Fidelity either!

OptionsXpress, ThinkorSwim, or Interactivebrokers are probably the top three choices. Each has their pros/cons depending on what's important to you.

If it's just for trade execution, etc, then Optionxpress is very good. They also have some decent rates (email me). They also match up to internal orders as well when they can. Additionally, they have some interesting scanning tools that can help you apply advanced strategies such as ratio spreads, etc to a stock.

Interactivebrokers is probably the cheapest. It's software based and takes a while to get used to. They route most of their trades through themselves, so that's one reason they are cheaper. You'll have to look at how active you are to see what fits best for you. Of the three, IB has the least desirable search tools, etc.

TOS is relatively new. They have some amazing tools and are very hungry for business right now (again, email me and I can help you with this). They have some great routing tools and have scanners specific to spreads, etc.They also (currently) have some fantastic free training as well. Executions have been decent as well. And in the long run, your executions'll be the most important.

With TOS and OXPS, I've been able to call their trading desk and they've been able to help with orders and/or take orders when I've not been at a computer to do the trade as well.

So, decide what's important to you. You might also check out Barron's annual article on brokerages that comes out in the spring.

If you have any further questions, I'll be glad to assist where I can.

Admin

Dani_boy 03.09.2010. 00:25

How can I emit or lunch a Future and a option on the Chicago financial Market? I am doing some research about futures and options for a finance class, so we are looking for information about this, but it has been very difficult to find information on How to release this type of values.

Can somebody help us? and if you had a link, it would be so much better.
Thanks

Dani_boy

Admin 03.09.2010. 00:25

I really do not understand what you mean by lunch a future - unless you are meaning LAUNCH a futures contract?

If this is indeed what you meant, it is relatively simple.

Assuming it is a stock options contract, you need to open up a options trading ( margin ) account, then be qualified to trade options at a specified level - there are 5 levels. The level you get approved for depends on your experiecne and sophistication in trading options.

Now you can trade.

You can sell covered calls, or buy calls and puts; you can sell uncovered puts ( or cash secured puts if you have the money ready to buy shares if assigned ). you can do strangles, straddles, Iron Condors, and other more exotic strategies.

At level 5, you can deal with index options.

All are risky, and you can lose several items your investment.

RFor on-line tutorials about options, go to the Chicago Board of Options Exchange

http://www.cboe.com.

Admin

iobfff 10.03.2008. 19:37

How can i make money using straddles or strangles? How can i make money using straddles or strangles?

iobfff

Admin 10.03.2008. 19:37

To start, I'll repeat a quote from Natenberg's book "Option Volatility & Pricing" (page 187).

"While there is no substitute for experience, most traders quickly learn an important rule: straddles and strangles are the riskiest of all spreads. This is true whether one buys or sells these strategies. New traders sometimes assume the purchase of straddles and strangles is not especially risky because such strategies have limited risk. But it can be just as painful to lose money day after day when one buys a straddle or strangle and the market fails to move, as it is to lose the same amount of money all at once when one sells a straddle and the market makes a violent move. Of course, a trader who is right about volatility can reap large rewards from straddles and strangles. But an experienced trader know that such strategies offer the least margin for error, and he will usually prefer other strategies with more desirable risk characteristics."

In that quote the phrase "straddles and strangles are the riskiest of all spreads" is emphasized.

If you accept that there is a high amount of risk, you must accept that results from trading straddles and strangles will in inconsistent, so any technique you choose will fail (lose money) some of the time.

Probably the most common techniques used is to buy a straddle or a strangle when you believe some upcoming news event (such as earnings, an FDA new drug ruling, etc.) will have a major impact on the price of the stock. The difficulty you will encounter is that everyone else knows that an event is coming up that could influence the stock price, and as a result implied volatility for the options will be high prior to the event and will almost always drop after the event occurs. When implied volatility drops, the extrinsic values (sometimes called "time premiums") of options drops. For a long straddle/strangle to be profitable, the price of the stock must change enough to overcome the loss in extrinsic value with a larger gain in intrinsic value.

I have seen people who improve their odds on long straddles/strangles by measuring the percentage move experienced by the stock on the day folllowing each of the last several earnings anouncements. They then use that percentage as a factor in deciding if the cost of a straddle/strangle is attractive for the next earnings announcement.

I will also comment that one person I know who has claimed to have the fairly consistent success buying pre-earnings stangles always ratios the calls and puts to make the overall position delta neutral.

Another way to make money using straddles and strangles is to sell them when you believe they are overpriced. This technique, at least in theory, will usually produce a small profit, but it is also capable of creating a very large loss (well over 100% of your maximum possible profit) if the stock moves violently in either direction.

Although the risk is high, and I am not recommending this strategy to anyone, I will say I have had more success selling straddles and strangles than I have had buying them. However, to make profits I have frequently had to adjust the positions after opening them to keep them delta neutral.

Admin

I love money 26.09.2007. 02:49

How to protect downside in Options purchases? How to protect downside in Options purchases?

Stop Order or any other better strategy so as not to loose too

Any advise on protecting your downside in options? I put 10% below but
if the stock opens lower it got executed and then stock went up so I
lost some good chunk of profits. I had used market stop order. Is there a better strategy? Thanks for advise.

I love money

Admin 26.09.2007. 02:49

Well, I trade share options a fair amout of times, so here goes. First, I assume you are buying naked call options and rhen putting a stop loss in for a 10% decline in price. Options, unlike stocks trade very thinnly and therfore tend to be more volatile. So a stop should be only good for the day, but if it went out in a day, you should have increased the %.
On the other hand, what you may want to consider is a straddle, which you buy an opposing put. So that in theory, when the stock price goes down and therfore the call price will also go down, the offsetting put will increase. Bear in mind, that the rate of change relative to the change in the underlying stock is directional and not proportional. In addition, what you lose on a call may not be totally offset by the put, but on some days for reasons we can only guess, the put will outperform the loss on the call. The benefit of thid dtrategy is you are not knocked out of the game and you have a better chabce of maxing your gains.
Last piece of advice, you have to watch this stuff constantly and always be prepared to cash out. Do your homework on the underlying stock because that is the reason you bought the option- price certainty in a short time frame.

Admin

gxl 26.11.2010. 04:59

Why do sellers sell call options n why do buyers buy put options? I really don't understand. If let's say under call option, the buyer can choose anytime to buy the underlying security, the buyer will definitely buy it when it's profitable for him. So the seller would lose out. Why would sellers Want to even sell call options in the first place?

gxl

Admin 26.11.2010. 04:59

"Why would sellers Want to even sell call options in the first place?"

Because not every stock goes up in price all the time. If the price of the share stays the same or goes down, the seller (or "writer") of the call option gains the premium he sold it for and the option will expire worthless to the holder. His primary risk is the holder will exercise and his shares get called away, but that will only happen if the price of the stock goes up. If it stays flat or goes down, he is golden.

If you own 100 shares of XYZ company and the stock has been trading flat for some time, selling a call on those 100 shares is a way to increase your income.

There are other reasons to sell a call as well, like when using various strategies such as a "Straddle" or a "Spread".

Admin

TBone 02.02.2007. 18:13

Can somewhere point me to a good site that allows me to quickly find volatile stocks? Please don't respond with "just google it" or finance.google.com or some other financial website. I've already done that, but just like there are "most traded" or "biggest gainers/losers" I would like to see most volatile (over some time period).

I want to start doing some options trading (specifically using a "straddle" strategy) and this data would come in handy.

Only responses with "sources" please, thanks.

TBone

Admin 02.02.2007. 18:13

Use a stock screener tool like StockFetcher:

http://www.stockfetcher.com/

Admin

Gue55h00 06.11.2008. 21:25

Can you suggest a simple strategy that combines an option position and a position in the underlying asset...? You have been following three-month call options on XYZ bank. You are not sure if $9 is fair price for the stock but you estimate that true volatility is 30%, lower than the 36% implied by the price of three-month call options with $9 strike. Assume the risk-free rate is 3%.
Can you suggest a simple strategy that combines an option position and a position in the underlying asset to exploit this knowledge? Would a delta-neutral trading strategy make sense?

Gue55h00

Admin 06.11.2008. 21:25

<<>>

One simple strategy would be to buy a number of shares and then sell at-the-money call options on twice as many shares. That would be the equivalent of writing an at-the-money straddle.

<<>>

Since you did not express any bullish or bearish bias, a delta-neutral strategy would make sense. The synthetic at-the-money straddle I mentioned would be a delta-neutral strategy.

--------

I should add that I am not recommending writing straddles. There are other strategies I would prefer, such as a vertical ratio spread or a short calendar spread, but they do not meet the criterion of combining an option position and a position in the underlying asset.

Admin

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