Straddles are not used that often in comparison to other options trading strategies. The reason for their lack of use is down to the fact that most traders don’t understand the concept of a straddle. Schaeffer’s Investment Research will look at the concept and the advantages of straddles below and why this strategy should be added to your trading toolbox.
For this discussion, Schaeffer’s Investment Research will be talking about long straddles (buying calls and puts) instead of short straddles (selling calls and puts). Short straddles are not recommended for inexperienced traders due to the high levels of risk and loss associated with them. What is a straddle when discussing options trading? A straddle is executed when you purchase a call and a put for the same strike price and the same expiration date. Risk is mitigated as the only capital at risk is the money that you’ve paid out in premiums.
John likes XYZ stock and feels that the stock will definitely move, but isn’t sure which direction it will move to. John would normally purchase a call or a put in this situation, but decides to execute a straddle instead. The stock price of XYZ is currently $34, John purchases both a call and a put for a $35 strike price with an expiry date that is two weeks away. John spends $35 in premium for the call option and $55 for the put option. Ideally, John needs the stock to either rise or fall enough to make more than the combined $90 in premiums that he paid out. If the stock trades flat at expiry, then John will lose the $90 in premiums that he paid out.
When Should This Strategy Be Used?
Straddles should be used if you feel that the stock will swing big in either direction. A great time to use this strategy should be before a catalyst is expected. That catalyst could be in the form of upcoming news on the stock or a quarterly earnings call. Keep in mind that premiums are usually higher in the weeks leading up to quarterly earnings, so it’s a good idea to purchase the option well before the catalyst. Also make sure that your expiry date is about a week after the expected catalyst, this gives you a little extra time for the stock price to move accordingly.
Going off of the example listed above, Schaeffer’s Investment Research will look at how John’s XYZ stock panned out in the straddle. John’s stock fell due to lower than expected earnings and we’re now approaching expiry. The day before expiry, XYZ stock is now trading at $29 a share and John sells his put option. Let’s see how the numbers look when the dust clears: John purchased the put option at a $35 strike price and paid a $55 premium for this option. John makes nothing on the call option as the option expires worthless, however, John makes $600 on the put option. When you factor in the $90 in premiums paid, John will have made a profit of $510 on the straddle.
If you would like to know more about straddles and other options trading strategies, contact Schaeffer’s Investment Research today to learn more.