Last week we ended a series of articles that dealt with the strategy known as a calendar spread. This type of strategy benefited from sideways trading in the underlying security. This week, we are starting new series on a strategy that is much different: a straddle.
Before we dive into the specifics of a straddle and set up a mock trade, let's take some time to review some of the important aspects of options trading that helps us understand how a straddle works. Traders need to understand the concept of delta and the importance of implied volatility. Exit strategies are important as well since a straddle is normally not a homerun hitting strategy. However, if a trader would like to see profits regardless of the direction a stock moves, then a straddle is a great strategy to learn.
A straddle is made up of a long call and long put, both using the same strike price and same expiration month. Initially, one might ask how money can be made when a trader owns both the call and put. Logical question considering that owning a stock and simultaneously shorting the stock would be a zero sum game. However, with options, profits can be made and we will show why this is the case during the weeks to come as we follow a mock trade using a straddle.
There are some key points that need to be followed for straddles to be successful.
- Find a stock that has low IV compared with historical volatility.
- Find a stock that has been in a tight trading range.
- Find a stock that has pending news in the next 4 to 8 weeks.
- Allow at least 30-days until expiration after the expected news event.
- Know your breakeven points so that appropriate exit strategies can be set up.
Before we search for and implement a real-world example, we need to better understand the workings of a straddle and why it is a popular strategy.
Options traders often hear the term "delta neutral," though I am sure many traders do not know what this means. Delta neutral is a simple concept that means the total delta of an options strategy equals zero. Obviously, it is important to know what delta is in the first place.
Delta is an option "greek" that tells traders the odds of the option finishing in the money [ITM]. Another way of looking at delta is that it is the amount made or lost for a point move in the underlying security. For example, if an ATM option has a delta of +50, it means there is a 50/50 chance it will finish in the money at expiration. This makes sense given the stock is currently trading at the strike price. It also means that for a point move higher in the underlying security, the option will increase its value by 50-cents.
Delta for a stock is +100 with the delta on a stock sold short at -100. This makes sense given that for every dollar move higher or lower in the stock, a resulting profit or loss of one dollar is made. For options, figuring delta is much more complicated, but we have computers to do the dirty work for us. In general, an ATM long call has a delta of +50 while an ATM long put has a delta of -50. This is why a straddle, which is made up of a long ATM call and long ATM put has a delta of zero or is delta neutral. This concept isn't quite as important for straddle traders that are not planning on making adjustments, but it still is a concept that helps traders make better trading decisions.
A risk graph is always an important part of the decision making process so let's look at a generic risk graph for a straddle. Before looking below, try to imagine what a straddle's risk graph would look like. Remember, it is the combination of a long call and long put.
Figure 1: Generic Risk Graph of a Straddle
While looking at this chart, try to think of the risks in entering a straddle strategy. The most obvious risk I see is a lack of movement by the underlying. This strategy only sees the max loss if the underlying closes at the strike price at expiration. In any strategy, we would like to mitigate the possible losses, so let's discuss some ways to do this with a straddle.
Since we are buying both a long call and long put, we have to pay double premiums. One of the biggest factors in the price of an option is its implied volatility. Thus, we need to find options that are showing low IV. This way we are lowering our vega risk, which would be the risk of IV falling lower. IV has a tendency to revert to its mean, which just means it will move lower and higher, but usually will come back to an average reading.
Another huge risk we have when owning two long options is theta risk. Theta is the "greek" for time decay. Unlike owning a stock, options are wasting assets, which mean they have a limited life span. As expiration approaches, time value erodes, with the last 30-days of an options life seeing the greatest amount of time decay. By setting up the trade so that we exit before this 30-day time frame, we are limiting our risk even more.
Understanding the breakeven points is important, because it gives us a good idea of how much the stock has to move to turn a profit. Straddles, unlike some option strategies, is not meant to be a homerun hitting strategy. Normally, traders are looking for a 50-percent profit. However, bringing in 50-percent in a month to two months time can add up to be huge gains over time.
The breakeven points for a straddle are very easy to calculate even without a computer program. We just need to add up the premiums paid to buy the long and short options and then subtract this from the strike price for the downside breakeven and add it to the strike price for the upside breakeven. Of course, by using Optionetics Platinum or any other options trading program, you can see a risk graph and all the resulting data for the trade you are investigating.
Next week, we will discuss ways to find good straddle stock candidates. We will also enter a mock trade using a real world example so that readers can see how the trade develops over time. However, I need to get feedback from readers so I can answer the questions and concerns you have. Please post any comments on my forum, which you may access through "Ask the Traders" from the Discussion board on the homepage of Optionetics.com., and I will make sure to get them answered either in the upcoming articles are directly on the discussion board.
Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site
