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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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The Information on the Site is provided for information purposes only. The Information is not intended to be and does not constitute financial advice or any other advice. The trading of stocks, futures, commodities, index futures or any other securities has potential rewards, and it also has potential risks involved. Trading may not be suitable for all users of this Website. Past performance is not necessarily an indication of future performance. You absolutely must make your own decisions before acting on any information obtained from this Website.

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