The Long Straddle And Price Consolidation

By Jay Kaeppel AAA

When a trader buys a given security or sells it short, that security needs to move in the forecasted direction in order for the trader to make money. In other words, if a trader buys a stock, that stock must advance in price for the trader to make a profit. If the price of the stock declines instead, the trader will suffer a loss. Likewise, if a trader enters a short position in a stock, then the price of that stock must decline in order for the trader to generate a profit. If the price of the stock rises instead, the trader holding the short position will lose money.

The bottom line is that the trader of the underlying stock must correctly choose the proper direction of future price movement in order to profit - unless he or she uses options.

Through the use of options, a trader can craft positions with entirely different risk/reward tradeoffs, including ones that do not require an accurate forecast of the direction of the next major price move. Read on to find out what options strategies can accomplish this goal and how traders can use them to their advantage. (For background reading, see Trading A Stock Versus Stock Options – Part 1 and Part 2.)

What Is a Long Straddle?
A long straddle is one option trading strategy that offers option traders a unique opportunity not available to individuals who only trade underlying securities. Specifically, a long straddle affords a trader the opportunity to make money regardless of whether the underlying security advances or declines in price. The tradeoff is that the long straddle will lose money if the underlying security remains close to the price it was at when the trade was initiated. However, the trader can position the trade to give the stock enough time to make a meaningful move. (For more on long straddles, see Profit On Any Price Change With Long Straddles.)

A long straddle is entered into by simply buying a call option and a put option with the same strike price and the same expiration month. A call option gains value as the underlying security rises in price and a put option gains value as the underlying security declines in price. However, both options have limited risk. Therefore, the goal is to have the underlying security either:

  1. Rise far enough to make a larger profit on the call option than the loss sustained by the put option, or
  2. Decline far enough to make a larger profit on the put option than the loss sustained by the call option.

This is how a long straddle makes money. (To keep reading about straddles, see Straddle Strategy A Simple Approach To Market Neutral.)

One of the two options must advance more in price than the other option declines in price. In addition, the maximum profit potential on a long straddle is unlimited. As long as the stock keeps moving further and further in one direction, the long straddle can continue to accumulate greater and greater profits.

Option prices are comprised of intrinsic value and time premium. Intrinsic value is the amount that an option is in-the-money. The remainder of the price of an in-the-money option and the entire price of an out-of-the-money option is comprised of time premium. Therefore, the risk in buying a long straddle is that the underlying security will not make a meaningful move in either direction and that both the options will lose time premium as a result of time decay. The maximum risk for a long straddle will only be realized if the underlying security closes exactly at the strike price for the options.

Looking for the Next Big Move
If you look at a price chart of virtually any security, you will find periods of price consolidation followed by price trends in one direction or the other. This trending period is then followed by another consolidation and so forth. If you look at enough charts, you will also notice that some securities are inherently more volatile than others. Because you need some type of meaningful price movement in order to make money on a long straddle, it then makes sense to consider buying a long straddle on a typically volatile security after it experiences a price consolidation.

A consolidation phase can often be quite subjective, but in the end the idea is simply to identify a period of time during which the stock in question has "gone nowhere". In addition, the more "tightly wound" the price action is during the consolidation - or, the longer and more narrow the trading range - the more likely the eventual breakout will involve a meaningful price movement. Some traders use various indicators to measure and identify consolidation, but it is possible to identify significant trading ranges simply by inspecting the price action for a given security on a price chart.

The first step is to identify a stock that has a history of making significant movements in price. Stodgy old blue chip stocks or utility stocks typically are not the best candidates for the long straddle strategy because they simply do not move significantly enough in price to generate a profit. What you really want are the high fliers that routinely make significantly large percentage price movements. In 2009, one such stock is Microstrategy (Nasdaq:MSTR), which appears in Figure 1 below. As you can see from a simple visual inspection of this chart, MSTR has a tendency to wind into a tight trading range and to then break out of that range with a large move.

Figure 1: Microstrategy (MSTR
Source: ProfitSource

Buying a Long Straddle Following Consolidation
Once a stock establishes a trading range over a 10-day period at least, the thing to watch for is a breakout in either direction. Many traders will attempt to play the breakout in the direction of that initial breakout: they will get bullish if the stock moves to the upside and bearish if it breaks to the downside. However, breakouts often have a high failure rate and whipsaws can leave those initial buyers or short sellers with a quick loss. This is why a long straddle can be quite useful in this situation.

For example, if the stock breaks out to the upside and keeps going, a long straddle will make money. Likewise, if the upside breakout fails and the stock turns and runs to the downside, the long straddle can make money in that case also. In Figure 1, there are three consolidation periods marked for MSTR. Each consolidation was followed by a significant move in price. If you look at the second set of parallel lines, which occurred during the month of May, you can see that the stock broke to the downside on June 2. In Figure 2, you see a long straddle trade that could have been entered using options on MSTR.

In this example, the trade involved buying one October 80 strike price call option for $7.80 and simultaneously buying the October 80 strike price put option for $9.30. Thus, this trade costs $1,710 to enter [($7.80 + $9.30) * 100 Shares per options contract].

Figure 2: Long Straddle using options on MSTR
Source: Optionetics Platinum

The Particulars of the Long Straddle
When you enter a long straddle, there are always three certainties:

  1. You have unlimited profit potential.
  2. Your risk is limited to the amount you pay to purchase the call and put options.
  3. Your breakeven points are equal to the amount you paid added to and subtracted from the strike price of the options purchased.

You can see these factors reflected in the risk curves that appear in Figure 3, below. On the left-hand side is the price chart for MSTR. On the right-hand side are the risk curves that depict the expected profit or loss at any given stock price as time goes by. You can see in these risk curves that the higher or lower the stock moves, the greater the profit. You can also see that the maximum loss is $1,710. This will only occur if MSTR is trading exactly at $80 at the time of option expiration. You can also view the effect of time decay, or the process by which an option loses whatever time premium was built into its price as expiration approaches. This is reflected in the fact that the risk curves shift to the left (reflecting either a smaller profit or a larger loss) as time goes by.

Lastly, if it is held until option expiration, then you can see that the breakeven points for this trade will be 62.90 and 97.10. These points are arrived at by adding and subtracting the amount paid to purchase the straddle (17.10 points) to the strike price of 80.

Figure 3: Risk Curves for MSTR Long Straddle
Source: Optionetics Platinum

Managing the Trade
Prior to entering a long straddle, it is essential to determine what would cause you to exit the trade with a profit or with a loss. Regarding risk control, some traders will set a percentage of the amount paid as a stop-loss point. Another possibility is to set a time limit. For example, a trader might decide to risk, say, 50% of the premium paid to enter the trade. For the MSTR example, this works out to about $850. As you can see above in Figure 3, if this trade was held until September 1 and the stock was about unchanged, then this trade would show a loss in the $800+ range.

In regards to profit-taking, different traders use a variety of different methods, but one of the simplest and most useful is a simple profit target. For example, a trader might decide to exit the position if a profit of a given amount or percentage is achieved. This comes down to personal preference and also depends on one's expectations for the underlying stock. However, it is not uncommon for a trader to target a 20-50% return. For the MSTR long straddle example, a profit target of 20% would mean that one would look to take a profit once the profit on the trade exceeds $342 ($1,710 * 0.2).

It took close to two months, but on July 28, MSTR finally fell far enough to generate an open profit of $430. The buyer of this long straddle could have exited the trade at this point and garnered a profit of 25% in just two months' time. The risk curves in Figure 4 are updated to reflect the change in the stock and the value of the long straddle position as of July 28.

Figure 4: MSTR stock drops, long straddle becomes profitable
Source: Optionetics Platinum

Summary
Taking advantage of unique situations is one of the benefits that option traders enjoy. One of those unique situations involves taking advantage of the fact that stocks - especially those that are extremely volatile in nature - will "pause" and consolidate from time to time. Eventually, that consolidation period ends. When it does, quite often it will be followed by a strong trend in the price of the stock. The problem is that it can be difficult to accurately forecast whether that new trend will be to the upside or to the downside. This is exactly the situation in which a long straddle can be quite useful. By buying a long straddle, or simultaneously buying both a call and a put option, a trader does not need to accurately forecast the direction of an impending price movement; he or she only needs to feel confident that a sufficiently meaningful price movement is likely to occur.

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