The straddle is an interesting options trading strategy as it is one where we have no idea on the future direction of the market, but feel sure that it will move significantly in one way or the other. The key word here is significant as the success of the trade depends on a major move in the underlying asset, which in this case would be the equity option. The trade itself is a net debit trade, since, as you will see we are buying two options simultaneously, which involves a net debit, rather than a credit as in other option trades.
For it to be successful, the straddle trade therefore depends on volatility entering the market, either directly in the underlying asset, or indirectly to the market as a whole. The straddle is a direction neutral strategy as it has no bias in either direction. Does this mean we just guess - NO. There are several aspects to the trade which we will consider in a minute, but you will need to understand about online option trading volatility along with Japanese candlestick analysis. I have presented these subjects elsewhere in detail so please click on the links for an overview on these topics.
Now, it is important to understand that there are two types of straddles, the first is a long straddle, and the second is a short straddle. The risk profiles for these strategies is very different. The long straddle is essentially a low risk high reward trading approach, whilst the short straddle is the exact opposite, a high risk limited reward. In my view I would never trade a short straddle as it exposes you to unlimited risk - a thing I never do in my trading. The risk reward profile for the long option straddle is very different and offers you a defined and limited loss, in return for unlimited profits. As with covered call writing this is a relatively low risk options strategy, and it is a trade you can exit if the required volatility does not appear by selling your options back before expiry.
OK, let's have a look at how the long straddle works and the research you have to do in order to find good prospects for this trade in your options trading.
Option Risk
Straddle Options: The long straddle is one of my favourite option trades, as it provides a low risk and defined loss, for the potential of unlimited rewards. Now I have to say straight away, that whilst that sound great in theory, finding the right prospects for trading this option strategy can be difficult, but not impossible.
However, even if the trade does not work in our favour, we can still exit the trade and avoid a 100% loss. So let's have a look at the risk profile for the trade and see how the straddle works.
Options Trading: Long Straddle - Risk Profile
The long straddle is constructed by buying an ATM ( at the money) put option and an ATM ( at the money) call option with the same expiry date and same strike price. The first element of the straddle is buying the put option.
The risk profile for this is shown on the left and as you would expect, as the underlying asset increases in value, then the put option falls in value. The downside risk of buying a put option is limited to the cost of the put itself i.e. the premium, so your loss ( whilst it could be 100% ) is capped when you buy the option, so you will always know your downside risk.
The second part of the straddle trade is to buy the call option which is shown on the right. Now here again, this is straightforward. As the underlying asset increases in value, so does your call option which you have bought. Should the underlying asset decrease in value then you call option will also decrease, but again your loss is limited to the amount you paid for the option, i.e. the premium.
Finally we put the two profiles together and arrive at the following risk profile for the option trade which is shown on the left. As we can see if the vertical grey line is our strike price, the downside risk is limited to the cost of the two option premiums added together which form the V below the horizontal breakeven line.
Above this line, whether the underlying stock falls in value or rises in value, our profits are unlimited, so we have two breakeven points, depending on whether the stock falls or rises. The key to success with this trade is to ensure that the underlying asset, the equity, moves sufficiently for us to move from loss to profit. So in summary our risk profile on the straddle is a follows :
Maximum risk is the cost of buying the two options (100%)
Maximum reward is unlimited
Breakeven above ( stock rises in value) - strike price less the premiums
Breakeven below ( stock falls in value) - strike price plus the premiums
Maximum risk - 100% of the premiums
So having establishes the trading risk reward profile for our long option straddle we now need to look at how we can find good straddle prospects and how we should manage the trade as time passes.
Option Trading Strategy
Straddle Prospects: Having established our trading risk profile for the long straddle option trade, we now need to find some prospects in the underlying asset. In this case we shall be looking at equity options and therefore the underlying stock or share is key to our selection.
Naturally from time to time the markets are volatile, but waiting and hoping for some rapid price movements are simply not enough. We can certainly include an analysis of general market conditions in the process, our primary requirement is for underlying stocks or shares that are likely to move significantly in price in the next few months.
Options Trading: Straddle Prospects : Key Elements
In choosing our straddle option prospects, there are four elements that we have to consider and these are as follows :
The price of the stock
The timing of the trade
The chart pattern
The implied and historic volatility
Options Trading: Straddle Prospects - Stock Price
Each of these is important so let's consider each one in turn. Firstly the price of the stock. Wherever you trade a straddle the key is that we are looking for a large movement in price so we do not want to open the trade on a low priced stock or share. For my own trading, I would only consider US stocks with a price in excess of $25, and in the UK in excess of £10. Remember that you do not know or indeed care which way the price moves, just simply that it does, so give yourself enough room on the downside, should prices fall sharply. You don't want to be trading the straddle on a stock or share valued at 1 or 2 USD and find that price movement is restricted by the physical price.
Options Trading: Straddle Prospects - Trade Timing
For those of you familiar with options, you will know that the greatest enemy to you as an option holder is that of time. As expiry moves closer, the time value of the option erodes exponentially, eroding faster and faster with the value of the option falling as a result until at expiry the time element of the option is zero. The straddle strategy depends for its success on you giving yourself enough time for the trade to succeed.
However, time comes at a price, as the longer the option contact period, the more expensive will be the premium. I would therefore suggest for the straddle that you consider a maximum of 3 month contracts only - any shorter then time will work against you more quickly, and any longer then the trade becomes more expensive.
Options Trading: Straddle Prospects - Chart Patterns
We will look at this in more detail overleaf, but in essence we are looking for prices which are consolidating on the chart.
Options Trading: Straddle Prospects - Volatility
In an ideal world we are looking for three things here. Firstly we would like the HV ( historic volatility ) to be low, and as we are looking at consolidating prices this is likely to the case. Secondly we would also like the IV to be lower than over the previous few months as this means that we are buying our options at an undervalued price ( in theory !) rather than at an overvalued price. Lastly we would also like the IV to to be lower than HV. Not much to ask!
Now let's have a closer look at the trading chart patterns that we need to find in order to identify possible straddle prospects.
Option Trading Basics
Straddle Charts: The most important part of stock selection for the straddle option is in selecting the equity using a technical trading approach from the candlestick charts. There are naturally many reasons why stocks and shares move sharply, resulting in significant movement in the options, and most occur when least expected. In the pharmaceutical industry this happens regularly, particularly if drugs are withdrawn from the market following adverse trials.
Company results can move prices dramatically as can the sudden resignation of a board member, or the rumour of a takeover or merger. As traders using the straddle we have to try to forecast a sudden and sharp price move in the future - we don't mind which way it goes, just so long as it goes! The best way to do this is to analyse the price chart for the particular stock and we are looking for one type of pattern in particular as follows :
Options Trading: Straddle Prospects Charts - The Pennant / Flag/ Triangle
We are looking for only one thing in our chart analysis, and that is simply a series of candles which are showing consolidation of prices as shown on the left. Now whether you call this chart pattern a pennant a flag or a triangle, it is clearly telling us that the price movement on the daily chart is becoming smaller, day by day. The purple lines simply connect the highest prices and lowest prices, and form a cone.
There must be a reason why this is happening? Is it because there is a major news announcement due in a few weeks time, are results expected soon that may not meet the market expectations, has the chairman resigned, are products about to be withdrawn from the market, have drug trials gone badly. There are many reasons for prices to consolidate in the above way, but they give us the perfect place to start in selecting our straddle prospects.
Having identified our prospects from the charts, we then need to start searching for the possible reasons. Check company results, read press releases between the lines, study the news, do some digging on the company - anything that may confirm to you that there is some hidden reason for this lack of price movement. Having done your research, if you feel there is a chance that prices will break out suddenly in the next three months, then open your trade by buying the put and call options with a strike price which is at the money ( or as close as possible ).
Options Trading: Straddle Prospects Charts - Managing The Trade
Having placed our straddle trade, we then have to wait for the price of the stock to move, far and fast, and our options to follow! Let's assume that the news item has moved the market and the stock price has increased dramatically. The call option will now be in profit and the put option in loss. The advantage of the long straddle is that as the option holder you can sell off the profitable leg ( the call ) and hold onto the other ( the put ) in the hope that prices reverse and you have two bites at the profit cherry!! The difficult decision as always is where to take your profits!
The second scenario occurs when the news announcement is made and nothing happens to the stock price. Personally I would leave it for a day or so and then close both options to avoid a 100% loss on the trade. Many traders live in hope and find this hard to do, but in trading it is the best strategy as some of your trading capital is retained, allowing you to live to fight another day and find another long straddle!
