Options Trading Strategy: Straddle Spread

Introduction

The straddle spread is a relatively simple options strategy that can be used under different market scenarios.

However its most normal use is a long position to take advantage of a large movement in the underlying share or index.

Description of the Strategy

A straddle spread involves either the purchase or sale of an at-the-money call and put. For example, if stock ABC is trading at $40 per share, a straddle spread would involve the purchase of the $40 call and $40 put or the sale of the $40 call and the $40 put.

It is therefore similar to the strangle spread.

If the trader is long the straddle, he or she is looking for the market to either make a significant move in one direction or for there to be a significant increase in implied volatility.

If the trader is short the straddle, he or she is looking for the market to either stay to close to the option strike price or for the market to see a significant decline in implied volatility.

When to Put it On

The straddle can be used when a large directional move is anticipated, but the trader is unsure of which direction the market may move in. It can also be used if the trader expects a sharp decline in implied volatility, and thus a corresponding decline in option values.

For example: Suppose that a trader has been watching stock RRR for some time. The stock is currently trading at $50 per share and has a big earnings announcement coming up. The trader feels that the company is likely to either report earnings that are far above analyst expectations, or to disappoint. The trader believes that the market could see a sharp move and break out of its recent trading range but is not sure which direction the move may take place.

The trader therefore decides to initiate a long straddle by purchasing the two month $50 call option and the two month $50 put option. The trader pays a total premium of $6 for the spread.

In order to break-even on the spread, the stock must make a $6 move in either direction. Once the stock has moved $6 away from the $50 strike price, the trader will profit point-for-point with the stock. So, if the shares moved higher from $50 to $60, the trader would be left with a net $4 profit on the straddle.

On the other hand, if the trader felt that the market would likely not see a sharp move and that implied volatility levels would decline following the announcement, then he or she could sell the straddle and collect the premium of $6. In this case, the trader could potentially profit if the stock stayed within $6 of the strike price when the options expire.

Pros of the Strategy

The biggest potential benefit to the straddle spread is the trader can potentially profit regardless of market direction. Rather than having to guess which way the market may move, he or she simply needs to try determine the magnitude of such a move.

The position can also potentially profit not just from a significant market move, but also from an increase in implied volatility.

Cons of the Strategy

If the trader purchases the long straddle, a significant market move may be needed to turn a profit. Not only that, but the options will also have time decay working against them. If the market does not move enough and do it sooner rather than later, the trader can lose money simply due to time erosion of the options.

If the trader sells the straddle spread, he or she is exposed to unlimited risk. The sale of a naked call or put carries with it unlimited risk, as the market could decline all the way to zero or theoretically go higher and higher. This is why many traders prefer the iron condor.

Risk Management

If the trader is long the straddle, there are numerous ways to manage the risk of the trade. A very simple way is to set a predetermined amount that the trader is willing to lose on the bet. Using the example above, if the trader pays $6 for the straddle, he or she could decide to cut the position if the value of the straddle declines to $4.

Managing risk if the trader is short the spread can be a lot trickier. The trader could use a similar approach to the above, but decide to cut the position if oit increases in value by a certain amount. They could also use price levels to cut the position as well. For example, if the market moves from $50 to $52 then cut the position. Due to its unlimited risk potential, a short straddle requires a lot of attention and solid risk management techniques. Even with strong risk management, however, the trader is still open to unlimited risk.

Possible Adjustments

A long straddle can be adjusted in several ways. If a potential market move is taking to longer to happen than anticipated, for example, the trader could sell back the current straddle and purchase a new one with more time until the options expire.

The short straddle can be a powerful weapon in the trader’s arsenal, but it must be used under the appropriate market scenarios. The long straddle can be a great way to capitalize on large market moves, but the moves must be large enough to cover the sizable premium paid for such a position. The defined risk nature of the long straddle can make it attractive as well, and it is a fairly simple options trade to manage.

Unlike the iron condor, the short straddle comes with unlimited risk and should only be used by those willing to assume such risks. Although the short straddle can potentially profit from time decay, such a position also has a tendency to blow up in the trader’s face on the rare occasions that the market does make an unusually significant directional move.