Straddle option strategy definition

Definition of straddle option strategy

Straddle option strategy defined as two legs of both ATM put and ATM call options. Options straddle by definition is market neutral. Therefore it can bring profits in both falling and rising markets. The catch being that market moves need to be volatile.  That is because a trader who chooses this strategy pays a big premium for being long two options. Ideally the trader initiates an straddle option strategy in calm markets before the rise of volatility.  The probability of profit is usually lower then 50% but maximum loss is highly unlikely. The options straddle holder has an unlimited profit potential.

Straddle option strategy breakdown

Straddle option strategy by definition consists of:

  • At the money long call
  • At the money long put

It’s worth noting that in real life the perfect at the money strike doesn’t exist. Because the price of the underlying is almost always  just a bit off the strike. Therefore a closest strike should be chosen. You must buy both the put and the call of this same strike! Otherwise you would be trading a strangle not an straddle option strategy. Definition is strict and those trades have completely different risk profiles. Despite trivial difference. For example options straddle will practically never bring back 0$ payout (assuming no transaction costs). Because the price at expiry would have to land exactly at the strike. Where as for even a tight strangle it is somewhat likely that a 0$ payout will happen.

Straddle option strategy Payoff Diagram

This diagram shows the graph of straddle option strategy

Limited risk

The investors risk is limited to the premium paid.

  • Maximum loss = call price + put price

Traders will initiate this strategy to hedge against wild market swings in unknown direction.

Unlimited profit potential

Options straddle holder could realize infinite profits. That is because the price of the underlying can rise without limits. In practice. Straddle rarely bring huge returns.  This is due to big premium paid.  Opening the trade during calm can lead to bigger returns. If market makes a sharp move.

Example

Let’s assume that XYZ stock trades at 100$. The options trader decides to open a straddle position. For that he/she buys a 100$ put and a 100$ call. Both of those for 2$ each. Now in order for the trader to realise profit, the underlying has to either fall below 96$ or rise above 104$. If the price stays within this range, the trader will suffer a loss. The point of maximum loss is at the underlings price of 100$. This corresponds to the strike prices of call and put. Therefore one of the biggest determinants of success with this options strategy is to buy it when options are cheap.

Straddle option strategy before earnings announcement

The theory behind this long straddle option strategy is that the buyer of the position expects a high degree of volatility after the company releases earnings. However they are unsure in which direction the price will change. The long straddle provides positive exposure to a significant price move in either direction, with a chance to profit as long as the price change is large enough to cover the premiums regardless of the direction of the change. Therefore this strategy has two break even point with the first one being the strike price plus the net debit paid and the other being the strike price minus the net debit paid.

Ideal conditions for straddle trade

Four criteria should be satisfied before buying a straddle. Implied volatility must be very low. Probability of a big move should be estimated and show that the stock has an about 80% chance of reaching the straddle’s break-even point. Analysis of historical movements in the underlying security needs to indicate that it has made such big moves in the required time frame in the past. And that there is no fundamental reason why volatility is low.

Straddle strategy as a volatility play

Buying a straddle is also a form of what is known as “trading volatility” because investors aren’t making a directional bet on a stock. They hope to profit merely from a dramatic movement and sharp rise in IV. Volatility buying strategy should be used in options with at least three months but, ideally, five or six months until expiration. Options that far away from expiration aren’t heavily affected by time decay — another important element in an option’s price.

Gamma scalping with straddle option strategy

It’s to start the trade as delta neutral as possible. That usually happens when the stock trades close to the strike. If the stock starts to move from the strike, you will usually roll the trade to stay delta neutral (gamma scalp). Rolling simply helps us to stay delta neutral. In case you did not roll and the stock continues moving in the same direction, you can actually have higher gains. But if the stock reverses, you will be in better position if you rolled.

Expiry selection

Usually it’s best to select an expiration at least two weeks from the earnings. In order to reduce the negative theta. The further the expiration, the more conservative the trade is. Going with closer expiration increases both the risk (negative theta) and the reward (positive gamma). If you expect the stock to move, going with closer expiration might be a better trade. Higher positive gamma means higher gains if the stock moves. But if it doesn’t, you will need bigger IV spike to offset the negative theta. In a low IV environment, further expiration tends to produce better results.

Good videos about straddles:

 

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