Purchase is an option strategy that can benefit if a stock moves up OR
down by a significant amount.
option-info and options-graphs sites:
Outlook: Very Bullish OR Very Bearish. Usually expecting a stock
to either continue an up or down move OR reverse. Or expecting a dramatic
move in the stock, but with the direction unknown, such as when positioning
before an earnings report.
Buy equal numbers of call(s) and put(s) at the strike price nearest
the current strike price.
when: Stock moves lower, past the lower breakeven, or stock moves
higher, past the upper breakeven.
Gain: unlimited to the upside, limited by the stock falling to zero
to the downside.
when: Stock does not move beyond one of the breakeven points.
Loss : Limited to the initial debit.
Calculation: Lower breakeven = strike price - total debit. Upper
breakeven = strike price + total debit.
compared to stock: Increased leverage, much less capital required,
"built-in" stop loss, don't need to pick a direction of movement.
compared to stock: Greater risk of 100% loss of the capital invested,
more stock movement needed to gain.
after entry, increasing implied volatility is positive.
after entry, the passage of time is negative.
Requirement : None. Initial debit must be paid in full.
Equivalent: Short stock and long twice as many ATM calls. Or, long
stock and long twice as many ATM puts.
- A Straddle
may be an attractive trade if you get the details right. The details
when a stock is about to move one way or another.
when volatility is low.
with enough time left to expiration for the stock to move past one
of the breakeven points.
- The situation
described above may exist when a stock is taking a "breather"
from a recent bullish or bearish move. At the current time, the stock
is generating no excitement one way or another, so the Implied Volatility
should be normal or low. If you enter a straddle at this point, you
can gain whether the stock resumes its recent direction, or reverses.
You will lose if the stock does not move before expiration.
that do not take volatility into account will have a tough time profiting
from straddles. For instance, a trader might enter a straddle when a
stock has just fallen sharply, expecting either another drop or a recovery.
However, the implied volatility usually rises when a stock drops. When
the stock continues the move or rises, the volatility may drop, and
the position will be hurt.
example is buying a straddle just before a company's earnings are to
be announced. This is usually a period of high implied volatility, because
stock owners increase the demand for protective puts, and speculators
increase the demand for both puts and calls. Then, after earnings are
out, there may be a "volatility crush", meaning volatility
returns to normal, so that even if the stock moves one way or another,
the option position can't get beyond the breakeven points. The breakeven
points are further apart if you enter a straddle during periods of high
volatility, because you are paying more for both long calls and long
philosophy for straddle buying is to purchase a straddle when you think
a stock is about to move, and as soon as it does move, sell your losing
options and keep the winning options. Now you know which way the stock
is moving and you are in a trade benefiting from the movement. At the
time you bought the straddle, you may have instead tried to guess on
a direction and bought just puts or just calls, and been totally wrong.
- And to
be fair, a contrary strategy for volatile markets is to take gains on
the winning side, with the expectation that the stock will not continue
a move, but will instead reverse and perhaps allow gains on the other
side as well.
- The trader
using a straddle in the normal way is expecting the stock to rise or
fall by expiration. If the stock does not rise or fall, it is usually
wise to exit the trade, taking less than the maximum possible loss.
Using the graph at the top of the page, you might exit if the stock
did not move within two weeks, and your loss would be about one third
the maximum possible.
- It is
probably best for normal straddle traders to use the axiom "cut
your losses short and let your winners run". If the stock is not
moving, exit with less than the maximum loss. If the stock moves one
way or another, stick with that side. Most stocks will not continue
one way forever, but the occasional stock that keeps moving until expiration
can make up for lots of losers.
a move one way or the other, the losing side can be sold off, leaving
just a long put or a long call.
- If the
stock continues to move, it is then possible to turn a long call into
a bull call, or a long put into a bear put, recovering some or all of
the loss on the losing side. However, this limits your gains if the
stock moves further than you think it will.