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.
that the movement of the stock is enough to cover the cost of the trade, you
should be profitable.
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
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.
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.
are the rules for trading straddles:
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
Only do a Straddle on a stock that is close to making an announcement, such as
the week before an earnings report.
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
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
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.
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.
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
to Trading a Straddle
1. Buy ATM strike puts, preferably with about three months to
2. Buy ATM strike calls with the same expiration.
this income strategy when a stock has been volatile and you anticipate a
significant drop in volatility.
is trading at $25.37 on May 14, 2011.
August 2011 25 strike put for $1.70.
August 2011 25 strike call for $2.40.
debit: premiums bought = $4.10
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 is limited to the net debit of the bought puts and calls. The reward is
Of Time Decay
And in the last month, time decay accelerates.
out of the position a few days after the news event occurs
the stock rises significantly, sell the call to make a profit and wait for a
retracement to profit from the put.
the stock drops significantly, sell the put to make a profit and wait for a
retracement to profit from the call.
out before the last month as time decay hurts your
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.