However, volatility trading can often mean a stock goes in a direction that is different from the way an investor intends. In this case, trading straddles can be an options trading strategy that can minimize the risk of an option trade no matter which direction the underlying asset trades.
When using a straddle strategy, both a call and a put option contract must be purchased at the same strike price and with the same expiration month. When a straddle is long, the trader is buying the calls and puts. The trader is anticipating that the underlying security is ready for a significant price movement, such as in advance of an earnings announcement. This means the investor is betting on the implied volatility of a security which is typically tied to its beta. When an asset that typically has a beta of above 1 has been trading in a tight range for a period of time, it is a good sign that it can be ready for a significant move.
Traders can also execute short straddles. In this case, the trader is selling the calls and puts. The potential gain for the trader is that the contracts and straddles will breakeven – meaning they will trade in a range that will cause the buyer to allow them to expire without exercising the option. In this case, the seller of the option has a maximum gain from the option premium they collected. However, executing a short straddle strategy can provide unlimited downside risk if the underlying asset departs significantly from the strike price.
Introduction
Options trading is a way for investors to speculate on the direction of a security without having to take ownership of the underlying asset. Option trades can be either call options (when the options buyer is expecting significant upward movement) or put options (when the options buyer is expecting significant downward movement). When the trader is unsure of exactly which way the movement will be, they can take a variation on options trading known as a straddle strategy. This strategy provides an additional hedge against price movement by allowing the trader an opportunity to profit even if they are 100% wrong about the anticipated movement of the security.
In this article, we'll take a closer look at straddles. We'll define what they are, how they fit into options trading and give examples for both long and short straddles. We'll also review the concept of beta and its importance to helping traders identify potentially profitable straddle trades.
What is a straddle?
A straddle is an options trading strategy that takes advantage of the implied volatility (i.e. the price movement) of an underlying asset even when they do not know the exact direction of that movement. In a straddle trade, an investor purchases a call option and a put option at the same time, for the same strike price and with the same expiration date. The reason for purchasing both a call and a put is because an investor may know the stock is likely to have high implied volatility. This means there is a strong likelihood that it will make a major move in one direction or another. At certain times – for example around earnings season – it can be difficult to forecast in which direction a security may move.
This is where the name straddle comes in. By buying both a call option and a put option, the investor is essentially “straddling” the security and attempting to profit no matter which way the underlying security moves. Straddles can be long (when the trader is buying the options) or short (when the trader is selling the options).
Before executing a straddle trade, investors should look for three things:
- What is the current option premium (this will provide confirmation of a security’s implied volatility)?
- Is there an upcoming event that may trigger significant price movement (such as an earnings report)?
- Are there technical indicators that suggest a breakout is about to happen?
An overview of options trading
Before we dive into the details of a straddle, it’s a good time to review the basic mechanics of every option trade. Every option trade has a buyer and a seller. When the option buyer is speculating that the price of a security is going to rise, they can purchase a call option. This gives them the right, but not the obligation, to buy a certain amount of a security (e.g. for stock option contracts, each option contract is worth 100 shares of stock) on or before the contract’s expiration date. If they anticipate the price of the stock will fall, they can buy a put option. This gives them the right, but once again not the obligation, to sell an amount of a security on or before the contract’s expiration date. The optional nature of the transaction is what makes options contracts different from futures contracts.
Once an options contract is purchased, there are three ways for the contract to go. If the underlying security stays at or right around the price of the contract, it is said to be “at the money”. If it goes above the price of the contract (for a call option) or below the price of the contract (for a put option), it is said to be in the money (an ITR option). If the underlying security goes opposite of the direction of the contract (down for a call option, up for a put option), the trade is said to be “out of the money” (an OTM option).
To help clarify this, let’s use an example where a trader purchases a call option on a stock that is currently trading at $30. The strike price (the price of the contract) is set at $30.50. If the stock price moves above $30.50, the contract is said to be in the money. If it drops below $30.50 it is said to be out of the money.
In a traditional options trade, the buyer of the option has virtually no risk, since they do not have to exercise the option on “at the money” or “out of the money” contracts. If the price of the underlying security does not move in their anticipated fashion, they can simply choose to allow the contract to expire worthless.
However, this does not mean that they will break even. In order to purchase an option contract, they have to pay a premium to the seller. This premium (also known as the option price) is calculated on a per share basis. So an option price of $2 means that the buyer of the option will have to pay the seller $200. If the contract is allowed to expire, the buyer of the contract is only out the amount of money he paid as a premium.
On the other hand, the seller of the option gets to keep the premium and because the contract was allowed to expire, does not have to pay the buyer any additional money either by buying shares from him or selling shares to him.
Example of a long straddle trade:
Here’s how a typical long straddle might work.
Step One: A trader purchases an “at-the-money” call option. If they are trading stock then the strike price (i.e. the exercise price) is the same as the stock price. For example, if the XYZ Company was trading at $35, the trader would purchase an option with a strike price of $35.
Step Two: At the same time they purchase the call option, they would purchase an “at-the-money” put option. Once again, the option would have the same strike price (exercise price) as the stock price – and it would also have the same price as the call option. In this case, they would buy a put option with a stock price and strike price of $35.
If the price of the underlying stock increases to $40, the trader could exercise the call option. This would allow them to buy 100 shares of XYZ Company stock at $35. They could then turn around and sell the stock at $40 per share. In this example, they would have a $500 profit.
If the price of the underlying stock fell to $30, the trader could exercise the put option. This would allow them to sell 100 shares of XYZ Company stock at $35 per share. Since the stock price is only $30 per share, they would again be looking at a $500 profit.
However, to determine if the trade was a good investment, an investor has to look at the cost of buying the option to determine their maximum profit. Remember, there is an option premium that comes with every contract. This premium goes to the seller. In the case of an "at the money" option, the premium is generally higher because there is a higher likelihood that the underlying asset, in this case, a stock price, will rise above the strike price. In our example, let's say the premium was $3 on either side. This means that the options buyer’s cost was $300 ($3 x 100 shares) for the call option and an additional $300 for the put option for a total cost of $600.
With that in mind, if the underlying stock rose to $35, the profit potential (in this case $500) would still leave the investor negative on the trade. This is one of the risks of straddle trades. The price of the underlying security must rise high enough to cover both sides of the trade. Some investment professionals advise never executing a straddle trade where you expect less than 100% return.
What is a short straddle?
A short straddle is a straddle strategy in which a trader is the seller of both the calls and puts. Remembering that the seller of an option is the one that assumes the risk, the strategy behind the short straddle is reaching a breakeven point where the underlying security, at the date of expiration, is either at the money (at the strike price) or out of the money (below the strike price for a call option; above the strike price for a put option). In either case, the option contract would expire worthless. In this case, the maximum gain for the trader will be the profit they collect from the option premium.
The risk in a short straddle strategy is their maximum loss could be unlimited as the underlying asset price could move up or down well beyond the strike price of the option.
The role of beta in a straddle
Every security has a beta value. This is a measurement of a security’s market volatility (i.e. price movement). For example, if a stock has a beta of 1 it means the price movement has a strong correlation to the market. These securities are also sometimes called delta neutral.
Options traders, and straddle traders, in particular, will choose securities with a beta above 1 because those are the ones that are actively traded and most likely to produce the price movement needed to ensure a successful trade. This means not only paying attention to a security's beta but looking at technical indicators to confirm a security’s recent performance. Even volatile securities will go through periods of low price movement. Investing in volatility is about taking advantage of these reversions to the mean. When a security has gone through a period of volatility it tends to trade in a tight range making it a poor candidate for a straddle trade.
The final word on straddles
Straddles are a variation on options trading that looks at the implied volatility of a security to anticipate when a large movement in either direction is anticipated. In the case of a straddle, the trader is not certain of which direction the security will move. This is usually because an event is coming up (an election, earnings report) that traditionally causes significant price movement.
Straddles are long when the trader is buying the option contracts and short when the trader is selling the contracts. In the case of the long straddle, the upside profit is virtually unlimited because an underlying asset can rise far above its strike price for a call option or to $0 for a put option. The only cost to the buyer is the option premium that is paid to enter the contract.
The short straddle introduces a larger risk to the seller, because they could be caught on the wrong side of a trade. However, the benefit is the profit they receive from collecting the option premium. This premium is maximized when the contracts expire at the money or out of the money. In either case, the buyer is not likely to exercise the option on the call or put.
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