There are numerous trading strategies designed to help traders succeed regardless of whether the market moves up or down.
Some are more sophisticated such as Iron Condors and Iron Butterflies, which are legendary in the world of options.
However, they require complex buying and selling of multiple options at various strike prices.
The end result is to enable the trader to profit no matter where the underlying price of the stock, currency, or commodity ends up.
Another popular options strategy to accomplish the same market-neutral objective is known as a Straddle, which requires the purchase or sale of one Put and one Call to activate.
Here are some benefits and pitfalls of the Straddle strategy.
An Options Straddle involves buying (or selling) both a call and a put with the same strike price and expiration on the same underlying asset.
A long straddle pays off when volatility increases, and the price of the underlying moves by a large amount, but it doesn’t matter whether it’s to the upside or the downside.
Types of Straddles
A straddle is a strategy 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.
The long straddle is designed around the purchase of a put and a call at the exact same strike price and expiration date.
It is meant to take advantage of the market price change by exploiting increased volatility.
Regardless of which direction the market price moves, a long straddle position will help the trader to profit from it.
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 option, a trader will collect the premium as a profit.
The trader wins 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 inability to move up or down.
If the market develops a bias either way, then the total premium collected will be in jeopardy.
The success or failure of any straddle is based on these advantages and limitations
A long straddle is designed to assist a trader to earn profits whether the market goes 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 are two choices available:
- The trader can pick a side and hope the market breaks in that direction.
- Or, the trader can also hedge his bets and pick both sides simultaneously.
By purchasing both the put and call, he is able to catch the market’s movement regardless of its direction.
If the market moves up, the Call wins; if the market moves down, the Put wins.
Drawbacks to the Long Straddle
The following are the three drawbacks to the long straddle
Risk of loss
Lack of volatility
The rule of thumb when it comes to purchasing options …
In-the-money and at-the-money options are more expensive than out-of-the-money options.
ATM Straddle (At-the-Money)
How quickly a trader exit from the losing side of the straddle will have an impact on the profitable outcome of the straddle.
If the option losses move 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.
All options are comprised of the following two values:
The time value comes from the option’s date to expiry.
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 chooses a direction, or the options expire worthless.
The Short Straddle
The short straddle’s strength is its drawback. Instead of purchasing a put and a call, they are sold to generate income from the premiums.
This can be a great reward for the trader who will earn the money spent by the buyers.
A profitable scenario involves the erosion of both time value and the intrinsic value of the put and call options.
As long as the market does not move up or down, the short straddle is fine.
The downside, however, is that when you sell an option, you are exposed to unlimited risk.
If the market picks a direction, the trader has to pay for the losses that accrue, but he must also give back the premium he collected.
The only recourse for the short straddle trader is to buy back the options that he sold when the value justifies doing so.
This can occur at anytime during the life cycle of a trade, or to hold it until expiration.
Best Case Scenario
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 make an announcement of a particular prediction, which can have an impact on how the market reacts.
A straddle, short or long, can be affected by the market scenario.
Prior to any earnings announcement, analysts will predict the value of the announcement. How the market reacts will affect the momentum of the actual price and decide if the straddle is profitable.
The classic trading adage is “the trend is your friend.”
The straddle is the great equalizer that allows a trader to let the market decide where it wants to go with both a put and a call.