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Straddle

 

Description

 

The Straddle is the most popular volatility strategy and the easiest to understand. You simply buy puts and calls with the same strike price and expiration date so that you can profit from a stock soaring up or plummeting down. Each leg of the trade has limited downside (i.e., the call or put premium) but uncapped upside.

 

Assuming that the movement of the stock is enough to cover the cost of the trade, you should be profitable.

 

However, you also need to apply various rules when trading straddles. The problem with buying options includes time decay and the Bid/Ask Spread. Time decay hurts long options positions because options are like wasting assets. The closer you get to expiration, the less time value there is in the option. Time decay accelerates exponentially during the last month before expiration, so you do not want to hold onto out-of-the-money or at-the-money options into the last month.

 

You also do not want to be buying and selling the same Straddle too frequently because typically the Bid/Ask Spread is quite wide, and if you continually buy at the Ask and sell at the Bid when the stock has not moved for you, then the spread will cause you to lose.

 

So you must have a number of reasons for getting in, staying in, and then getting out. You also need to know that the price that you are paying for the Straddle is reasonable in comparison to the propensity the stock has to making a significant move. In other words, the cheaper the cost of the Straddle, the better, provided that the stock is one that can and will move explosively.

 

 Here are the rules for trading straddles:

    

1. It is better to choose stocks over $20.00, preferably no more than $60.00. Thats not to say that you can not make profits from stocks  outside of that range.

 

2. Only do a Straddle on a stock that is close to making an announcement, such as the week before an earnings report.

 

3. Buy at-the-money calls and puts with the expiration at least two months  away, preferably three. You can get away with four months if nothing else is available.

    

4. The cost of the Straddle should be less than half of the stock’s recent  high less its recent low. By recent, we mean the last 40 trading days for a two-month straddle, the last 60 trading days for a three-month  straddle, or the last 80 days for a four-month straddle. The point here is that the cost of the Straddle should be low in comparison with the potential of the stock to move.

    

5. Exit within two weeks after the news event occurs. Try to avoid holding the position during the final month before expiration. In the final month, options suffer from accelerating time decay, which would therefore erode your position.

 

6. Try to find a stock that is forming a consolidation pattern, such as a flag  or pennant, or in other words, where the stock price action has become tighter and where volatility has shrunk in advance of a big move in either direction. You should familiarize yourself with the basics of technical analysis at the very least.

 

 

 It is  important to follow the entry and exit rules for straddles, and psychologically speaking, the Straddle is a tough strategy to play after you’re in.

 

Steps to Trading a Straddle

    

         1.    Buy ATM strike puts, preferably with about three months to expiration.

    

          2.    Buy ATM strike calls with the same expiration.

 

 

 

Market Opinion

 

Directional neutral.

 

P/L

 

 

 

 

 

 

When To Use

 

Use this income strategy when a stock has been volatile and you anticipate a significant drop in volatility.

 

Example

 

XXXX is trading at $25.37 on May 14, 2011.

Buy August 2011 25 strike put for $1.70.

Buy August 2011 25 strike call for $2.40.

 

Net debit: premiums bought = $4.10

 

Benefit

 

The benefit is the possibility of making a profit from a stock, whether it moves in either direction, with capped risk and unlimited profit potential.

 

Risk vs. Reward

 

The risk is limited to the net debit of the bought puts and calls. The reward is unlimited.

 

Net Upside

 

Net Downside

 

Break Even Point

 

Effect Of Volatility

 

Effect Of Time Decay

 

Negative. And in the last month, time decay accelerates.

 

Alternatives Before Expiration

 

Trade out of the position a few days after the news event occurs

 

If the stock rises significantly, sell the call to make a profit and wait for a retracement to profit from the put.

     

If the stock drops significantly, sell the put to make a profit and wait for a retracement to profit from the call.

    

Trade out before the last month as time decay hurts your position.    

      

Alternatives After Expiration

 

Close out the position by selling your puts and calls. You can also close out your profitable let and wait for the unprofitable leg later on.

 

   

         

 

 

 

    

         

 

 

    

    

 

 

 

 

    

 

    

  

    

 

    

 

 
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