Credit: Shutterstock photoThe straddle options strategy is employed by traders expecting a significant move from an equity, but who are unsure of the direction of this move. Additionally, since the strategy relies heavily on dramatically sharp moves in the underlying security, many traders like to employ straddles ahead of major events like earnings announcements, the release of drug-trial data, or product announcements. The bigger the potential impact on the stock, the more likely it is that a straddle position will finish with a profit.
Constructing a Straddle
Putting together a straddle position is really quite simple. After selecting a potential target for the trade, the investor will simultaneously purchase an equal number of puts and calls with the same strike and expiration date. Generally, these options will be as close to the money as possible, since at-the-money options have less intrinsic value and are therefore less expensive. However, if the trader has a directional bias (i.e., he has a hunch that the underlying stock will rally instead of decline), the straddle can be structured so that the call option is in the money and the put option is out of the money, and vice versa.
Ultimately, the objective of the straddle strategy is for the profit on either the call or the put option to outweigh the loss sustained on the other. Since the loss on either option is limited to the premium paid to acquire it in the first place, the trader needs the underlying stock to move above or below the straddle strike by at least the amount of the net debit paid in order to achieve a profit. Luckily, this net debit represents the position's maximum loss. The maximum profit, meanwhile, is theoretically unlimited on the upside, and bound by the difference between the straddle strike and the net debit on the downside.
Breaking Down an Example
The best way to fully appreciate the potential of this options strategy is to take a look at an example. After conducting a healthy degree of research, you discover that while XYZ Corporation ( XYZ ) shares have a history of solid long-term price action, the stock can become quite volatile following a quarterly earnings release. Along those lines, you feel that the company's upcoming quarterly report could be an opportunity.
Lining yourself up to benefit from post-earnings volatility, you decide to enter a straddle position on the security. With XYZ stepping into the earnings confessional on Aug. 5, you decide to place your straddle in the August series of options. Noting that XYZ is currently trading just shy of $18 per share, you purchase one August 18 put, last asked at $0.58, and one August 18 call, last asked at $0.29. As a result, you wind up with a net debit of $0.87, which represents the most you can possibly lose on the position.
Potential Outcomes
There are a couple potential outcomes for this straddle position. Under the best-case scenario, XYZ will either rally significantly beyond $18.87 per share (the upper breakeven level) or plunge below $17.13 per share (the lower breakeven level). For example, let's assume that the company's quarterly report is cheered by investors, and XYZ rallies to $23 per share by August options expiration as a result. In this case, the purchased August 18 put would expire worthless, while the August 18 call would be worth $5. Subtracting the net debit of $0.87 paid at initiation, your profit comes in at $4.13.
On the other hand, let's assume that XYZ's earnings are panned by investors and analysts, and the stock plunges to $13 per share. In this case, the purchased August 18 call would expire worthless, while the August 18 put would be worth $5. Subtracting the net debit of $0.87 paid at initiation, your profit comes in at $4.13.
The only way to lose in this example is for XYZ shares to have practically no post-earnings reaction, leaving the shares between the aforementioned breakeven levels. However, even in this worst-case scenario, your losses are limited to the net debit of $0.87 paid at initiation.
Wrapping Up
It may seem like the long straddle is the answer to the indecisive trader's prayers, but options strategies that revolve around high levels of volatility are rarely as cut and dried as they seem. As such, it is vitally important to keep a few things in mind before initiating this strategy:
- High levels of historical volatility are beneficial to a straddle position, but they can also increase the cost of entering the trade. Specifically, high implied volatility levels relative to the stock's historical volatility can lift the cost of the straddle's options, thus pushing your breakeven rails further out. In other words, the more expensive the options, the further the stock will have to move to generate a profit, and the more capital you're putting at risk.
- Trading around events, such as earnings reports and trial results, can be extremely risky. The shares are just as likely to remain inert as they are to rally or plunge sharply. Furthermore, such events also impart higher levels of implied volatility to an option's price, thus increasing the move needed in the underlying shares in order to reach breakeven.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
