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The Straddle Purchase is an option strategy that can benefit if a stock moves up OR down by a significant amount.

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Strategy: Straddle Purchase

Straddle Purchase Option Graph

The 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.

The Trade: Buy equal numbers of call(s) and put(s) at the strike price nearest the current strike price.

Gains when: Stock moves lower, past the lower breakeven, or stock moves higher, past the upper breakeven.

Maximum Gain: unlimited to the upside, limited by the stock falling to zero to the downside.

Loses when: Stock does not move beyond one of the breakeven points.

Maximum Loss : Limited to the initial debit.

Breakeven Calculation: Lower breakeven = strike price - total debit. Upper breakeven = strike price + total debit.

Advantages compared to stock: Increased leverage, much less capital required, "built-in" stop loss, don't need to pick a direction of movement.

Disadvantages compared to stock: Greater risk of 100% loss of the capital invested, more stock movement needed to gain.

Volatility: after entry, increasing implied volatility is positive.

Time: after entry, the passage of time is negative.

Margin Requirement : None. Initial debit must be paid in full.

Synthetic Equivalent: Short stock and long twice as many ATM calls. Or, long stock and long twice as many ATM puts.

Comments

  • A Straddle may be an attractive trade if you get the details right. The details are:
    • Entering when a stock is about to move one way or another.
    • Entering when volatility is low.
    • Entering 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.
  • Traders 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.
  • Another 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 puts.
  • Another 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.

Exits

  • 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.

Adjustments

  • After 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.

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