As a regular reader of this blog, you have already read about some of the clever, and often creative, strategies that options traders come up with to beat the market.
One of those techniques is a multi-position approach known as “the straddle.” Along with the related “strangle”, it is a way of securing your position against unpredictability and, while expensive, can prove very profitable under the right circumstances.
So how does it work? Well, here are the basics:
In a straddle, the investor will take both a call and a put option on the same stock with the same strike price and expiration date. Usually the investor will purchase both contracts at-the-money (in other words, with the strike set to the stock’s current price).
The goal is to create a position which is secured against unpredictable swings in the marketplace. Whether the stock exceeds or misses the strike price, at least one of these contracts will wind up in the money.
So why doesn’t every options trader do this? What could be better, after all, than a strategy that pays off against the bulls and the bears?
In a word, premiums. In a lot more words, the problem with a straddle is that it depends on wide swings to cover its doubled-up premiums.
Every straddle position has to pay for both the call and the put contracts. This means that it is not enough for the stock price to beat the strike, it has to do so by enough to overcome those high costs and still make a profit. These are called the upper and lower breakeven points. The upper breakeven point is the point where the call makes more than the combined price of both premiums; the lower breakeven point is the point where the put option does so.
That is not always easy to clear, which means this is a strategy to use when you expect something big to happen in the underlying stock but you are not quite sure what.
The Long Straddle
Vanilla or chocolate, flight or invisibility, Smokey or the Bandit, there are a lot of famous choices in this life. (That last one was a trick.)
Add to that list the long or short straddle, each of which is defined by how you take out your positions.
The long straddle is the basic vanilla version, as described above. The advantage to this position is virtually unlimited profit, as the price can always go higher, while the risk is limited to that window around the strike price where you cannot cover your premiums.
However, as noted above, this also requires a wide enough swing in stock price to cover those combined premiums. Except in periods of high volatility, that often does not happen.
The Short Straddle
The alternative straddle for the seller’s side, the short is when you sell both a put and a call option on the same stock at the same strike price and expiration date.
Like buying a long straddle, this is a way for an options writer to cover his position. However, the short straddle differs in one critical way. This is a limited profit, unlimited risk position for the very same reasons outlined above.
The goal of a short straddle is to profit from both premiums without having to pay either option contract, so the strategy pays off during periods of low volatility. As long as the stock price stays largely consistent relative to the strike price, the seller can have his cake and eat it too.
If the market starts to get jittery though, this one can turn bad fast, making the short straddle an options trading strategy that is utilized less frequently than a long straddle.
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