You know a big move is coming you just have no clue which direction!
You can just "feel" the energy building in the stock - maybe it's before earnings or some big FDA approval.
Whatever the case, a big move is coming and now with the Straddle options strategy you can profit from a move in either direction. Stock traders can't touch this with a 10-foot pole.
But how do you set up this option strategy properly for the stock you are watching? Let's discuss. . .
Quick Straddle Strategy Basics
The long straddle is an options strategy that's created by both buying a single call and a single put. You can set this up in various forms by widening out the strikes, but for the purposes of keeping this simple we are only going to talk about the basic straddle.
To initiate a Straddle, we would buy the call and put of a stock with the same expiration date AND strike price. For example, we would initiate a Straddle for company XYZ stock by buying a June $100 Call and a June $100 Put.
For simplicity let's assume each option cost $5 so you spent in total $10 to enter this position.
The key here is that the strike prices are the same. Whatever area you want to "center" the trade around, make sure that you are buying and selling the same strike price option on both sides.
Positioning For A Big Move
We know how to create it now but why would we want to set up a strategy this way?
In a perfect market, we would be able to predict clearly the next move of the stock. However, we live and invest in the real world.
Calls are for when you expect the stock to go up, and Puts are for when you expect the stock to go down - why are we trading both at the same time? Don't they cancel each other out?
All valid questions but the short answer is NO. . .
The reality of this situation is that we have no clue what will happen or where the stock will trade - none. Therefore, we need to position ourselves for a move in either direction.
Remember that this strategy is made up of two single options each purchased for $5. Our total $10 investment is the most we could lose on the trade if the stock just stays right here at $100 the entire time.
But, this same $10 investment also helps us determine our break-even points for the big move we expect. From the chart above you just add/subtract your cost ($10) to the strike price of $100 = giving us the break-even prices of $90 and $110.
Non-Directional Profit Potential
For example, let's say that XYZ's annual report is coming out this week, but you don't know whether they will exceed expectations or not. You want to get in on the action but don't want a one-sided bet since you haven't a clue that direction the stock will move.
You adopt the Straddle as your go-to option strategy. . .two things can happen from here:
- If the price of the stock shoots up after the announcement, your Call will be way ITM, and your Put will be worthless. But you'll still make money.
- If the price falls hard on missed expectations, your Put will be way ITM, but your Call will be worthless. Again, you'll still make money.
If you had just bought one option or the other and the price goes against you, you're looking at possibly losing your entire premium investment. In the case of Straddles, you will be safe either way.
And having the break-even points is very important for your understanding of the strategy. This allows us to see visually where the stock needs to move up or down for us to make money after all is said and done.
The beauty of this strategy is that we can make money in either direction (so long as it moves far enough). Stock traders cannot do this - they have to place a bet one way or the other.
When Does This Strategy Fail?
By now you are saying, "Kirk if this strategy is so good why doesn't everyone trade them?"
Straddles fail in two major scenarios. First, volatility is already high assuming the stock will have a big move and the premiums have this priced in. Thus, you were paying the additional premium for a move that is already expected to happen.
Second, the stock fails to move far enough or fast enough past your break-even points. What you thought would be a big move ended up being a small trend or no move at all! Stinks, but it happens.
In both cases the premiums of both the Call and Put will slowly drop and fall, leaving you with two potentially worthless options at expiration.