In trading, there are numerous sophisticated trading strategies designed to help traders succeed regardless of whether the market moves up or down. Some of the more sophisticated strategies, such as iron condors and iron butterflies, are legendary in the world of options. They require a complex buying and selling of multiple options at various strike prices. The end result is to make sure a trader is able to profit no matter where the underlying price of the stock, currency or commodity ends up.
However, one of the least sophisticated option strategies can accomplish the same market neutral objective with a lot less hassle - and it's effective. The strategy is known as a straddle. It only requires the purchase or sale of one put and one call in order to become activated. In this article, we'll take a look at different the types of straddles and the benefits and pitfalls of each.
Types of Straddles
A straddle is a strategy that is accomplished by holding an equal number of puts and calls with the same strike price and expiration dates. The following are the two types of straddle positions.
- Long Straddle - The long straddle is designed around the purchase of a put and a call at the exact same strike price and expiration date. The long straddle is meant to take advantage of the market price change by exploiting increased volatility. Regardless of which direction the market's price moves, a long straddle position will have you positioned to take advantage of it.
- Short Straddle - The short straddle requires the trader to sell both a put and a call option at the same strike price and expiration date. By selling the options, a trader is able to collect the premium as a profit. A trader only thrives when a short straddle is in a market with little or no volatility. The opportunity to profit will be based 100% on the market's lack of ability to move up or down. If the market develops a bias either way, then the total premium collected is at jeopardy.
The Long Straddle
A long straddle is specially designed to assist a trader to catch profits no matter where the market decides to go. There are three directions a market may move: up, down or sideways. When the market is moving sideways, it's difficult to know whether it will break to the upside or downside. To successfully prepare for the market's breakout, there is one of two choices available:
- The trader can pick a side and hopes that the market breaks in that direction.
- The trader can hedge his or her bets and pick both sides simultaneously. That's where the long straddle comes in.
By purchasing a put and a call, the trader is able to catch the market's move regardless of its direction. If the market moves up, the call is there; if the market moves down, the put is there. In Figure 1, we look at a 17-day snapshot of the euro market. This snapshot finds the euro stuck between $1.5660 and $1.54.
While the market looks like it may breakthrough the $1.5660 price, there is no guarantee that it will. Based on this uncertainty, purchasing a straddle will allow us to catch the market if it breaks to the upside or if it heads back down to the $1.54 level. This allows the trader to avoid any surprises.
Drawbacks to the Long Straddle
The following are the three key drawbacks to the long straddle.
- Risk of loss
- Lack of volatility
The rule of thumb when it comes to purchasing options is that in-the-money and at-the-money options are more expensive than out-of-the-money options. Each at-the-money option can be worth a few thousand dollars. So while the original intent is to be able to catch the market's move, the cost to do so may not match the amount at risk.
In Figure 2 we see that the market breaks to the upside, straight through $1.5660.
This leads us to the second problem: risk of loss. While our call at $1.5660 has now moved in the money and increased in value in the process, the $1.5660 put has now decreased in value because it has now moved farther out of the money. How quickly a trader can exit the losing side of straddle will have a significant impact on what the overall profitable outcome of the straddle can be. If the option losses mount quicker than the option gains or the market fails to move enough to make up for the losses, the overall trade will be a loser.
The final drawback deals with the inherent makeup of options. All options are comprised of the following two values.
- Time Value - The time value comes from how far away the option is from expiring. (For more insight, read The Importance Of Time Value.)
- Intrinsic Value - The intrinsic value comes from the option's strike price being out, in, or at the money.
If the market lacks volatility and does not move up or down, both the put and call option will lose value every day. This will go on until the market either definitively chooses a direction or the options expire worthless.
The Short Straddle
The short straddle's strength is also its drawback. Instead of purchasing a put and a call, a put and a call are sold in order to generate income from the premiums. The thousands that were spent by the put and call buyers actually fill your account. This can be a great boon for any trader. The downside, however, is that when you sell an option you expose yourself to unlimited risk. (For related reading, see Options Hazards That Can Bruise Your Portfolio.)
As long as the market does not move up or down in price, the short straddle trader is perfectly fine. The optimum profitable scenario involves the erosion of both the time value and the intrinsic value of the put and call options. In the event that the market does pick a direction, the trader not only has to pay for any losses that accrue, but he or she must also give back the premium he has collected.
The only recourse that short straddle traders have is to buy back the options that they sold when the value justifies doing so. This can occur anytime during the life cycle of a trade. If this is not done, the only choice is to hold on until expiration.
When Straddles Work Best
The option straddle works best when it meets at least one of these three criteria:
- The market is in a sideways pattern.
- There is pending news, earnings or another announcement.
- Analysts have extensive predictions on a particular announcement.
Analysts can have tremendous impact on how the market reacts before an announcement is ever made. Prior to any earnings decision or governmental announcement analysts, do their best to predict what the exact value of the announcement will be. Analysts may make estimates weeks in advance of the actual announcement, which inadvertently forces the market to move up or down. Whether the prediction is right or wrong is secondary to how the market reacts and whether your straddle will be profitable. (For more insight, read Analyst Recommendations: Do Sell Ratings Exist?)
After the actual numbers are released, the market has one of two ways to react: The analysts' prediction can add either to or decrease the momentum of the actual price once the announcement is made. In other words, it will proceed in the direction of what the analyst predicted or it will show signs of fatigue. A properly created straddle, short or long, can successfully take advantage of just this type of market scenario. The difficulty occurs in knowing when to use a short or a long straddle. This can only be determined when the market will move counter to the news and when the news will simply add to the momentum of the market's direction.
There is a constant pressure on traders to choose to buy or sell, collect premium or pay premiums, but the straddle is the great equalizer. The straddle allows a trader to let the market decide where it wants to go. The classic trading adage is "the trend is your friend". Take advantage of one of the few times that you are allowed to be in two places at once with both a put and a call.