Hello, Power Profit Traders!
Is there a way to trade options regardless of market direction? The answer is YES!
Utilizing technical analysis tools and following general stock trends are helpful in determining if a trend is bullish or bearish. Events, however, like FDA approvals on pharmaceutical companies, and, more commonly, earnings reporting every quarter, can create uncertainty about a stock’s next move.
Earnings events can create high demand in options due to speculation and stock hedging. This uncertainty and high demand can cause a stock’s price to move opposite of what your technical analysis may otherwise suggest.
When the direction of a stock’s price becomes questionable, a directional trade becomes a coin toss – leaving you with a 50/50 chance on making the right choice!
Straddle trading takes the guess work out. Straddles can profit if the stock’s price rises OR falls as speculation ramps up.
The Straddle
Buying a call option is a bullish, directional trade and benefits when the stock’s price rises. Alternatively, when a trader has a bearish posture, a put option is bought to benefit from falling stock prices.
Combining a call and put trade with the same strike price and same expiration creates a Straddle trade. Because a call and put are being purchased together, the cost of the investment is much higher than buying a single contract by itself. All this means is that the stock’s price can go up or down to be successful, but a stronger move is typically required.
(Straddle example: WMT Jul 22, $124 call and $124 put)
In the example above, the bullish call option would cost $3.08 by itself. Adding the $2.83 cost for the put contract, creating a Straddle, would bring the combined cost to $5.91.
Profiting from Straddles
Calls and puts both have extrinsic value (time value) built into their premiums. Since time takes a toll on an option’s premium, your profit potential on a Straddle is best when the stock moves solidly sooner than later.
To calculate a Straddle’s breakeven point at expiration, simply add the combined cost of the trade to the strike price for upside break even, and then subtract the cost from the strike price for downside break even.
In our example above, the upside breakeven is $129.91, and the downside breakeven is $118.09 illustrated by the graph below.
(Straddle b/e points denoted by black line, at expiration)
From the graph above you can see from the red, blue and green lines that Straddles can be profitable before the options expire, with less price movement.
Straddle trading is a great way to trade events, particularly when you’re not completely certain about which direction the stock’s price may go.
Although Straddles may seem intimidating at first glance, just remind yourself that the trade is simply a long call and a long put that are purchased together with the expectation that the security will make a strong move – in either direction.
Considerations before trading Straddles
With all trading strategies, it’s important to think about the overall objective and analysis before putting on real trades. Here are some things to consider before entering Straddle trades.
- The combined cost of the call and put – Risk management and budget
- Implied Volatility – Buying Straddles when IV is low can assist in a successful outcome, particularly when IV is expected to rise over the duration of the trade
- The magnitude of the stock’s movement. Since Straddles cost more than the individual call or put, the trader will require a stronger movement out of the stock’s price – expectations for price movement
Now that you’ve got a basic understanding of the Straddle design and considerations before trading them, I’m ready to show you how to build a Straddle. Click below to see how it’s done.
BUILDING A STRADDLE
Once you’ve decided the conditions warrant a Straddle instead of picking a specific direction for the stock to move in, the Straddle strategy is a straightforward trade that takes the guess work out of picking direction.
Until next time,
Tom Gentile
America’s #1 Pattern Trader
