As a reminder, options have a high risk-to-reward nature due to their use of leveraging and can hedge current equity positions you may have.
There are 4 different types of options (long call, short call, long put, short put) so, naturally, there are several different strategies that involve the use of two or more of these options in a creative way.
Care to learn about one?
A straddle is a strategy designed to benefit from market volatility. When used correctly, a straddle will reap profits should the underlying stock move in either direction, up or down.
However, should the underlying stock remain flat during the period before your options expire, you will lose the premium you paid for those options.
While losing 100% of your initial can seem like a great risk, don’t forget that the amount you are paying for options to control a large block of shares is far less significant than what it would cost to own those shares. In the end, every dollar you spend on options can harvest an ROI that is usually exponential compared to the ROI if you were to simply buy those shares in the market.
Options trading can seem well worth the risk, as long as it’s done strategically.
Let’s Hop On
To begin deploying the straddle strategy, ensure you are choosing a stock that you expect to move either up or down. This could be a stock that is currently trending sideways and awaiting a breakout, or a stock that is simply prone to additional market volatility for any reason.
3 opportune conditions to look for before taking advantage of volatility are:
- The market is in a sideways pattern.
- There is pending news, earnings, or another announcement.
- Analysts have extensive predictions on a particular announcement.
Straddles are composed of two options.
First, let’s look at a long straddle, which means you are purchasing the right to buy/sell the underlying stock at the strike price.
You’ll need to buy a long call, and a long put. These two options must be derived from the same underlying stock, have the same strike price, and the same expiry date. For this example, we will use GameStop ($GME), which at the time of writing, ended the day at $186/share afterhours.
- GME C185 5/21
- GME P185 5/21
These two options are both for GameStop, they both have a strike price of $185, and both expire in May. Now that you own these two options, you’ve paid the option writer the premium on both of them, and you’re ready to play the waiting game.
Out-of-the-money options will always be less pricey. For this example, we used options that were right on-the-money, likely consisting of a little bit of time value along with the intrinsic value.
Now, you won’t make money as soon as $GME inches in either direction. There is always an area of overlap where if the stock hasn’t moved far enough, you will still be at a small loss. There is a break–even price as well, which indicates at the necessary stock price at expiry, for you to not lose, nor make, any money
How are you supposed to find these prices?
Use a Calculator
To retrieve this information before you place any trade, we recommend you head over to the Options Profit Calculator.
Under “Straddle,” if you input the aforementioned options, you will receive a comprehensive chart, as well as the following info:
Entry cost: $2,958.00 – This consists of the cost of buying these two options.
Maximum risk: $2,958.00 at a price of $185.00 at expiry – This means if this stock stays put at your expiry date, your maximum risk will be losing precisely the amount of money you spent.
Maximum return: infinite on upside – This means that there is no limit to how high a stock can go, therefore your upside return is unlimited. Your downside return, should this go to $0, is limited, however such a scenario would be obviously disappointing.
Breakeven prices at expiry: $214.60, $155.40 – This means that should the price move up or down to either of these points, you will be at a breakeven.
With this info, you are now aware that you will be making money if $GME either surges past $214.60/share or sinks below $155.40/share. Anywhere in between, you are at a loss. The biggest loss is 100% of your initial, should the price expire exactly at the strike.
The benefit of a straddle is that these two options counteract each other, only up to a certain point. Once you are outside of your range, you are profitable.
A short straddle is simply deploying the same strategy, except writing the calls and puts instead. This provides you a premium from the long option buyer. This premium is yours to keep, as long as the stock doesn’t move outside of the range, which is defined by your two breakeven points.
Unlike a long straddle, short straddle traders benefit from a stock that is stable, with little price movement, and low volatility.
Let’s See the Numbers
Let’s find out exactly what our profit would be if $GME were to go volatile and either tank, or surge.
First, let’s see what would happen if $GME ran up 50%, to $280/share.
Options Profit Calculator produces a chart for you after you input your option trade. From there you can hover over the projected stock price, at the selected date, and see what your profit would be.
In this scenario, this straddle would yield a profit of $6542, or 221%, if $GME hit $280 at expiry. 221% is not too shabby for a 50% move in price.
How about if $GME tanked 40% and fell to $112/share?
In this scenario, the straddle would yield a profit of $4342 or 147%, if $GME hit $112 at expiry. Not bad getting almost 2.5x your money on a 40% movement!
In essence, straddles allow you to place a safer bet on both sides, not having to risk being wrong. The only risk to straddles is if the stock doesn’t move past either of your break-even prices (or does, if you are on the short side). This range differs greatly depending on the price of your options, which depends on how close they are to the money.
The long straddle strategy is best suited for stocks that are volatile and prone to large swings.
The short straddle strategy is best suited for stocks that are fairly steady and don’t move too dramatically.
We encourage all of you to head over to this useful website and punch in some straddles of your own!