Straddle Option Strategy - Profiting From Big Moves
Do you want to catch big moves in the stock market? In this article, we’re going to show you the art of trading straddle option strategy to catch the next big move. If you’re just getting started, we already covered the basic concepts on options trading that you need to know.
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The people who are successful at trading over a long period of time share some common characteristics. Number one is they all focus on high probability trade setups. The straddle strategy forex can help you accomplish that.
If you want to invest in a stock, the share of that stock has a probability of 50/50 chance of going up or down. There are only two probable outcomes. Now, stock options trading open another door of new opportunities.
Some option strategies that you can use will not start off with a 50/50 probability. The straddle option strategy is one of those strategies that can produce a high probability rate of success.
But what is a straddle option strategy?
What is a Straddle Option Strategy?
Basically, the straddle strategy is selling a put option and selling a call or buying a put and buying a call option at the same time. In other words you buy/sell a put and a call at the same strike price and at the same expiration date.
When buying straddle we want to stock price to move significantly either up or down. On the other hand, the short straddle options strategy requires the stock price to remain unchanged.
Is straddle a good strategy?
Let’s use the example of a stock trading at $50.
Now, the straddle means buying (or selling) at the money call option and buying (or selling) at the money put option. To simplify things we’re going to assume that the $50 strike call is worth $1 and the $50 strike put equals a $1 too.
The cost of buying the put option and the call option will be $2. In other words the straddle call strategy will cost you $2.
In this situation, the put option is going to make you money if the stock tanks and the call option are going to make you money if the stock price skyrockets.
If the stock goes down to zero, you will exercise the put option and sell the stock for $50. The put option gives you the right to sell the stock for $50. In this case, the call option is worthless and you don’t want to exercise it if the stock is already trading at zero. You wouldn’t want to buy something for $50 that’s worth zero.
In the case the stock price is trading above $50, you wouldn’t exercise the put option but instead you would want to exercise your call option.
However, if you believe the stock price will stay in a tight range between let’s say $48 and $52 we want to use the sell straddle strategy. When the market is going to “sleep” we’re collecting the premium from selling the trade options.
Note* When you buy options you pay the premium. When you sell options you’re collecting the premium.
Straddle Call Strategy
The straddle call strategy gives you the advantage of only taking a fixed amount of risk and higher rewards because the rewards are limited. However, buying straddle has a lower probability rate.
The time is also in the favor of the straddle seller.
Note* The person who sells a straddle is going to win most often because the odds are in their favor.
The pay off diagram, factoring in the costs also, will look something like in the figure below:
You will only make money with the long straddle strategy if the underlying stock price goes up significantly.
Moving forward in this step-by-step guide you’ll learn some tips and other information you need to improve your profitability with the straddle strategy.
Before implementing the straddle strategy you need to make sure you check the four requirements:
- Simultaneously buy (sell) a put option and a call option.
- The straddle option should have the same underlying stock.
- Same strike price.
- Same expiration date.
The implied volatility is a big part of an option’s price because the higher the volatility, the more you’ll have to pay for the option. In this regard, the best time to buy a straddle option is when the implied volatility is at its lowest.
When the implied volatility will increase this will benefit your long straddle trade.
Periods of contraction in implied volatility are always proceeded by periods of expansion in implied volatility. When the implied volatility picks up, we’re going to have big moves in price. This will help either the put option or the call option, depending in which direction the stock price goes.
For example, if you look at Teslas’ implied volatility over the last year, we can see that after each period of low activity it has quickly and swiftly moved higher. In this situation, a good strategy is to buy straddle because when the volatility goes up, the Tesla stock price will experience a big move either up or down.
Options with low implied volatility are considered to be cheap options. The cheap options have the advantage of offering small profit losses if you’re wrong on the trade.
Let’s now compare the straddle call strategy or the long straddle with the short straddle strategy.
Let’s suppose the ABC stock is trading at $100. An option trader will enter a long straddle position by buying a Dec 100 put for $4 and a Dec 100 call for $4. The total premium he pays to open the long straddle is $8, which is also the maximum loss he can take.
If, at expiration date, the ABC stock is trading at $120, the Dec 100 put will expire worthless, but the Dec $100 call will expire in the money. In this case, our option trader will make $12 ($20 from the sale of option -$8 from the premium he pays to go long the straddle).
The straddle call strategy will make you money even when the underlying stock price is going down.
If, at expiration date, the ABC stock is trading at $80, the Dec $100 call will expire worthless but the Dec $100 put will expire in the money. In this case, our option trader will still make $12 ($20 from the sale of option - $8 from the premium he pays to go long the straddle).
However, if our option trader will enter a short straddle by selling a Dec $100 put for $4 and a Dec $100 call for $4, he will be collecting the premium of $8 from the option trader who is buying the options.
In this case, for our option trader to make money, he needs the ABC stock price to move no more than $4 in either direction by the options expiration date.
Conclusion – Straddle Option Strategy
In conclusion, you want to use the straddle call strategy or to get long straddle if you want to benefit from a major price movement.
However, on the other hand, if you believe the stock price is going to be unchanged you want to use the short straddle options strategy. Selling straddle works best in a ranging type of environment.
The straddle call strategy has unlimited profit potential and a limited risk. The only risk you take is the premium you pay when you use a straddle call strategy. On the other hand the short straddle strategy works best in a range type of environment.
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