Options Theory: Long Straddles/Strangles
We can divide the numerous options strategies can into four different buckets: bullish, bearish, neutral, and bi-directional. Today, we’re focusing on the final group. These are plays you use when expecting glass shattering, explosive outcomes in either direction. Think of it as a way to befriend volatility.
Let’s begin with the long straddle. It involves buying an at-the-money call, and an at-the-money put in the same expiration month. The fact that we’re combining a bullish trade (long call) with a bearish trade (long put) is what makes it bi-directional. Here’s an example on a stock that we expect to bust a move, but aren’t sure of which direction.
XYZ @ $60
Buy July $60 call for $4.30
Buy July $60 put for $4.30
Net Debit: $8.60
The initial debit of $8.60 represents the max loss and will be forfeit if XYZ sits at $60 at expiration. The potential reward is unlimited, so consider your profits unfettered regardless of how high (or low) the stock travels.
For an alternate view of the strategy, take a gander at the accompanying risk graph.
It’s “V” shape reflects how you can profit whether the stock rises or falls. The key is it needs to move enough. This is a fact that many novices overlook. It isn’t enough to say that a long straddle makes money if the stock rises or falls. It only makes money if the stock moves more than expected.
Think of it this way. The $60 July straddle costs $8.60. That means the market, that is, the collective wisdom of all buyers and sellers, is pricing-in an $8.60 move higher or lower in the stock between now and July. By purchasing the straddle you’re effectively betting the stock will move more than the $8.60 by expiration.
This is a key element to consider when buying a straddle. Consider first the current price. Size-up how much movement is priced in based on the cost. Then, and only then, can you make an informed decision on if the straddle is a good trade. In the case of our example, $8.60 translates into a 14.33% move ($8.60/$60). If you think the stock has the mustard to rip or dip more than 14.33% in that time frame, then buy the straddle.
Here’s another key point: The quicker you exit, the less you need the stock to move. That’s because long straddles carry negative theta. So, ideally, you buy a straddle and the very next day the stock explodes. If it takes too long for the anticipated volatility to materialize you will end up with a loss.
To illustrate how the stock needs to move more to offset time decay the longer you’re in the position, here’s a risk graph that shows the trade’s evolution. Notice how the breakeven points (red hashes) move further away as time passes.
To the extent possible you want to purchase straddles as close as possible to the expected price move. Obviously, this is easier said than done.
There are two scenarios I can think of where long straddles are worth a shot. First, when an event is coming up like a Fed announcement or earnings release, and you believe options are underpricing how much the stock will move.
Second, when a stock is flashing a chart pattern such as a symmetrical triangle that suggests a big move could be imminent.
In both cases it would be ideal for implied volatility to be low. That’s another tell-tale sign that options might be underpriced.
Straddles have a twin strategy known as strangles. They exhibit the exact same characteristics and differ only in structure. Here’s how a long strangle might be structured on XYZ.
XYZ @ $60
Buy July $65 call for $2.00
Buy July $55 put for $2.00
Net Debit: $4.00
Instead of purchasing a pair of at-the-money calls and puts, the strangle involves buying out-of-the-money options. The overall cost (and thus risk) is lower, but the breakeven points are typically wider. Here’s what the risk graph looks like:
Final thought: bi-directional trades are only to be used in specific situations. They’re not a cash flow strategy like covered calls so they aren’t going to be consistently entered on a particular stock. Furthermore, because you’re buying options they are lower probability trades but can pay out handsomely if volatility really does rock the house.
Give the trade a whirl and return and report if you have questions.
