Only in options can you take a neutral position that pays off if the underlying moves up or down. Only in options can you make a neutral position that pays off if the underlying doesn't move at all. These are the reasons we love to trade options. An endless combination of strategies can be deployed to reach your desired effect.
The straddle is an easy position to use, but it can be difficult to profit from unless you stack the odds in your favor. Not only will we teach you how to do that but we are also going to show you how to set up the position, make adjustments, and when to take your profits.
How To Setup A Straddle
The significant advantage when using straddles is that they are easy to set up. Most option strategies require you to pick the right strike price and expiration from an almost infinite list of choices. Straddles, on the other hand, are typically set up in the same fashion.
A long straddle consists of buying a call and a put at the same strike at the same expiration month. Short straddles are comprised of selling a call and a put at the same strike and expiration month. Since the success of straddles relies on movement and volatility, either increasing or the lack thereof, you want to place your position in the front month or back month options.
When you place a long straddle, you think the stock is going to move away from its current price, either higher or lower. On the other side when you short a straddle, you believe the stock is going to stay at its current price. For these reasons, straddles, long or short, are typically placed on at-the-money strikes.
When To Use Long Straddles
When you are long a straddle, you have bought the at-the-money call, and at-the-money put either in the front month or back month. Since you are long two options, you have two breakeven points. For your upside break-even point, you take the strike you traded plus the total cost for the call option and the put option.
An example will help make this clear.
You want to buy a straddle on The Option Prophet (sym: TOP). TOP is currently trading at $45, and the at-the-money call is currently trading at $3.50, and the at-the-money put is trading at $3.25. Your breakeven to the upside is $51.75. We arrived at this number by taking our strike price (45) and adding the call price (3.50) and the put price (3.25) to it.
Our breakeven to the downside is just as easy to figure out. All you need to do is take your strike price minus the cost of the call and minus the cost of the put. Using our example from above, our downside breakeven is $38.25. This is figured by taking our strike price (45) and subtracting the call price (3.50) and the put price (3.25).
As we've noted, a long straddle needs a lot of movement in price and volatility. An increase in volatility will benefit the position more than your price movement but to be safe, it is always good to have both. When volatility increases, it will increase the price of both your call and put options by your Vega Greek no matter which direction the underlying moves.
Our first step to determine if we want to deploy a long straddle strategy is to see where implied volatility is trading. Implied volatility is forward-looking and shows the "implied" movement in a stock's future volatility. It tells you how traders think the stock will move. Implied volatility is always expressed as a percentage, non-directional and on an annual basis. There are several ways we can analyze implied volatility. We can track the implied volatility on a chart either through your brokerage or with a sophisticated tool such as LiveVol, or we can use a more straightforward method such as volatility percentile.
Another way you can track volatility and that is more practical for everyday traders is through volatility percentile. Volatility percentile is a ranking method that shows you how the current implied volatility compares to the stock's volatility over the last year. The percentile ranges from 0 to 100 where a reading of 0 would mean implied volatility is at its lowest level, and a reading of 100 would mean implied volatility is at its highest level.
When trading long straddles, we want to look for a volatility percentile that ranges between 0 and 30. This means volatility is at a low compared to recent volatility which means our options will be cheap plus there is a good chance for implied volatility to increase.
Now, what happens when our trade doesn't work out for us. If our trade doesn't work out, we can rest assured that we have a limited downside. We can only lose as much as the total cost of the trade. Returning to our example above, where the call cost $3.50, and the put cost $3.25, we can only lose a max $675 per straddle. The math to figure that out: ($3.50 + $3.25) x 100.
While our downside is limited in the debit that we paid to put on the trade our profit potential is unlimited. If our underlying makes a large move in either direction and volatility increases we can see our position profit substantially.
The significant negative to long straddles is the effect time decay has on our options. Since we are long two options, we will feel the time decay on both options.
The Exception To The Rule
There are always exceptions to the rules, and this one is no different. The one time it is better to be a long straddle in high volatility is when you are trading an earnings announcement. Surprisingly, the options strategies that perform well during earnings are long options. This goes against what most traders believe because they think volatility crushes the premium too much to make these trades profitable. However, there are a lot more earning surprises than not. When focusing on long options, we want to focus strictly on long straddles.
When focusing on taking a position for earnings, we want to get long our straddle at-the-money. Earnings can take a stock on a positive or negative track, so we don't want to put on a bias when entering our position. Keeping the position at-the-money will allow us to profit if the move is in either direction. When deciding on the maturity always pick the shortest time to expiration. We need the most movement and most reaction out of the straddle.
When To Use Short Straddles
When you are short a straddle, you have sold the at-the-money call, and at-the-money put either in the front month or back month. Since you are short two options, you have two breakeven points. For your upside breakeven point, you take the strike you traded plus the total credit for the call option and the put option.
An example will help make this clear.
You want to short a straddle on The Option Prophet (sym: TOP). TOP is currently trading at $25, and the at-the-money call is currently trading at $1.20, and the at-the-money put is trading at $1.25. Your breakeven to the upside is $27.45. We arrived at this number by taking our strike price (25) and adding the call price (1.20) and the put price (1.25) to it.
Our breakeven to the downside is just as easy to figure out. All you need to do is take your strike price minus the credit of the call and minus the credit of the put. Using our example from above our downside breakeven is $22.55. This is figured by taking our strike price (25) and subtracting the call price (1.20) and the put price (1.25).
Short straddles make a good strategy if you believe the underlying is not going to move. Now, this isn't typically a winning prediction since your betting on a minimal range to last over a month or two. We need a way to improve our probability of success.
The best way to turn a short straddle into a winning strategy is by placing the trade when implied volatility is high and starting to come in. When talking about implied volatility coming in we want to make sure we are not chasing volatility higher. There is no point in trying to "guess" implied volatility's top. What happens in this scenario is you predict a top and enter the trade, volatility continues to move higher, and now you are sitting on unrealized losses. Wait until volatility turns around and begins to head lower.
If we can't get a hold of an implied volatility chart, we want to use volatility percentile. When looking at the percentile try to narrow your trades down to underlying's that have a percentile that ranges from 70-100. In this range, it means volatility will be at least higher than 70% of the previous readings over the last year.
When volatility begins to come in, it will lower the value of both your call options and put options, which is exactly what we want in a short position. In fact, if volatility begins to come in while the stock is in our range the position should show a nice profit.
The negative to running a short straddle is that you have unlimited risk on both sides. If your underlying overshoots your call and continues to run higher, your position will take on losses, possibly heavy losses. Likewise, if your underlying falls down below your short put your position will begin to take on losses. Don't let a strategy that has limited profit potential and unlimited risk potential dissuade you. Short straddles can be highly effective if used inopportune times. However, even the best-laid plans can turn against you which is why we need an effective strategy to manage our positions once placed.
How To Adjust A Long Straddle
When it comes to adjusting a long straddle, we don't need to adjust for protection. Our losses are limited by the debit we pay. The position will start in the negative and move to the positive if our assumptions are correct. Therefore, when discussing adjusting a long straddle, we need to talk about adjusting when we have a profit.
The best way to protect your profits on a long straddle is by gamma scalping. This sounds complicated, but the process itself is simple. Scalping will involve buying and selling stock around our straddle to neutralize our deltas. The added benefit of this is it forces us to buy low and sell high or sell high and buy low.
For example, we have a long straddle on TOP that is performing well. TOP has begun to rally, and our position is starting to profit. Now that our calls are becoming more in-the-money we will begin to show positive deltas on our position. Let's say our straddle now shows a delta of 50. If we want to lock in our profit and protect ourselves if TOP begins to move lower from here we need to go out and short 50 shares of TOP. This will move the position back to delta neutral. The advantage to this method is that if TOP does begin to move lower we are now delta neutral, and our short position will start to make money. If TOP were to settle back at its original price our straddle would settle close to its original price and now we can buy back our short shares for a profit.
Adjustments like this can be made at any time but be wary of adjusting too much. Keep in mind you have to account for commissions and the likelihood of the underlying continuing to move in one direction. If the underlying runs up, you take a short position to adjust, and the underlying continues to run up you will cut down on your profits and have to make another adjustment. Adjustments like these take practice but having them in your toolbox will be helpful.
How To Adjust A Short Straddle
When it comes to short straddles, you don't want to make too many adjustments. The best offense is a good defense in this case, and by that, we mean buying insurance on your position when you place it. Do you know the saying, "stocks take the stairs up but the elevator down"? Stocks tend to go up slowly but melt down quickly. For this reason, we need to add protection to our downside.
When shopping for proper insurance, we want to look at cheap puts in our underlying at the same expiration as our short straddle. The puts we want to target are what we call units. When searching for units, you want to start at options with deltas between 2 and 5. This means for an average priced stock the option will be worth $0.25. These are the options that are built for insurance. They will sit around at approximately the same value until it comes time to explode in price. If your stock or the market doesn't drop, they will quietly fade away from your portfolio.
When you are purchasing insurance for your position, you don't want to spend more than 5% of your total credit. That should be plenty of protection to keep your position safe from a large downside move.
One of the adjustments we don't want to see is a trader rolling their position around trying to chase the underlying. Rolling positions can get traders in trouble because they put on excess risk in a bad position.
Knowing When To Take Profit
Knowing when to take profit can be just as challenging as knowing when to cut the losers and walk away. When you are dealing with straddles, both long and short, you are looking to take profits quickly.
On short straddles, you are looking at taking profits when you reach at least 20% of your credit. The idea is to not hang on to these until expiration. Remember you are counting on a tiny range for a very long period. Trying to ride these out till the end usually ends up in losses. If you are stacking the odds in your favor and waiting for high implied volatility to come in, then when it comes in, take the position off. Too many traders will get the move they expected but continue to hold until things turn around on them.
Long straddles are the same way. If you get a significant move in price or volatility, go ahead and remove the position or adjust it and lock in profits. Underlyings won't typically run in one direction nonstop. They will make a large move and settle back down. Like we mentioned earlier if you get your expected move don't push the envelope hoping for more.
If you are expecting a large move but don't know the direction and volatility is low, a great strategy is to go with a long straddle. These options can explode in price when you get your expected move. Even though it is ideal to pull the position off when you get the move you are looking for there are adjustments that can be made. If you want to lock in profit, you can routinely long and short the underlying as it moves.
If, however, you are expecting very little movement and for volatility to start to drop, the short straddle is a great go-to strategy. When employing a short straddle, the goal is to not hang on to it till the very end, but take it off when you have received at least 20% of your credit. When placing a short straddle remember you need to watch that downside drop so protect yourself by buying position insurance.
When do you like to trade option straddles? Let us know in the comments...