Straddle Options
Trading
A straddle may be bought when a trader expects a large
market move but is unsure of its probable direction. The strategy is
usually applied in a flat market when volatility is low or when there is
also the case of an �event-driven straddle�, such as before earnings
announcements or before an FDA meeting. In such cases, the market may
not be flat and volatility may actually be very high.
Straddle buying involves both a long call and a long
put on the same asset, using identical strike prices and expiration
dates. If the market makes a major move before the options expire, there
is an unlimited profit potential for the call option and a large profit
potential for the put. Meanwhile, the maximum potential loss remains
limited to the total premium paid for the two option positions (plus
commissions).
Particularly in a flat market, technical indicators
may conflict each other. Quite commonly, flat markets ultimately resolve
with an explosive move in one direction or another; however, it is not
always possible to anticipate in which direction the breakout will
occur. A trader who buys both call and put options may thus be able to
profit from such a situation, provided the market moves quickly enough
and far enough. While one option may then appreciate quickly in value,
the other can often be liquidated at a small loss; however, be aware
that time erosion works against the straddle buyer. During the entire
time a trader stays in a position in anticipation of a major market move
- yet the market stays flat and exhibits low volatility - the time value
of both the puts and the calls will erode constantly.
It is a good strategy to buy at-the-money or
close-to-the-money puts and calls. It is also desirable to invest equal
amounts into the puts and calls (doing otherwise would imply a market
bias � either bullish or bearish). Buy puts and calls with at least 3
months to expiration, thus giving yourself enough �time to be right�
(i.e., for the market to make its move). As noted, do not remain in
straddle too long, as time works against the option buyer should a rapid
move of the underlying not materialize.
A word about the cost of this strategy: Because
you are buying both puts and calls, you are incurring commissions on two
separate option transactions. The cost of buying a straddle is thus
quite high.
Summary of the straddle buying strategy: If the
underlying stays in a tight range (flat market) and doesn't break-out
strongly and quickly, a straddle buyer may lose money because of the
time erosion associated with the position. On the other hand, if the
market makes a major break-out soon enough, the trader can quickly
liquidate the losing side of the trade (thus minimizing losses) while
maintaining the winning position (which has the potential to bring
considerable profits).
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