How To Profit Trading Straddles
On the outside, a long straddle seems like a great option strategy.
If you’re betting the stock is going higher while simultaneously betting the stock is going lower all you need the stock to do is move! How could you lose?
As we’ve all experienced, it’s just not that easy. Buying two options means your breakeven is twice as large, it takes a large move to make any money, and you have twice the time decay working against your options.
Straddles are not all bad however. They can make you a lot of money if you position your trade correctly. By timing your position with the right levels of implied volatility, you increase your probability of success and odds of making money.
A Quick Primer On Volatility
Volatility is the heart and soul of option trading. With the proper understanding of volatility and how it effects your options, you can profit in any market condition. The markets and individual stocks are always adjusting from periods of low volatility to high volatility, so we need to understand how to time our option strategies.
When we talk about volatility, we are referring to implied volatility. Implied volatility is forward looking and shows the “implied” movement in a stock’s future volatility. Basically, it tells you how traders think the stock is going to move. Implied volatility is always expressed as a percentage, non-directional, and on an annual basis.
The higher the implied volatility, the more people think the stock’s price will move. Stocks listed on the Dow Jones are value stocks, so a lot of movement is not expected. Therefore they have a lower implied volatility. Conversely growth stocks, or small caps found on the Russell 2000, are expected to move around a lot- so they carry a higher implied volatility.
The Basics of Straddles
The big advantage when using straddles is that they are easy to setup. Most option strategies require you to pick the right strike price and expiration from an almost infinite list of choices. Straddles on the other hand, are typically set up in the same fashion every time.
A long straddle consists of buying a call and a put at the same strike and the same expiration month. Since the success of straddles relies on movement and volatility, you want to place your position in the front month or back month options.
When you trade a long straddle, you think the stock is going to move away, either higher or lower, from its current price. For this reason, long straddles are typically placed on at-the-money strikes.
Straddles are non-directional; they are delta neutral. They do, however, respond to movement (gamma) and volatility (vega).
When Should You Purchase Straddles
The absolute best time to purchase a straddle is when implied volatility is at its lowest. What will benefit your position more than movement? An increase in implied volatility. When the stock moves, it will help either the call or the put, depending on the direction. When volatility increases, it will help the call and the put.
When you look at Google’s implied volatility over the last two years, you can see that it is currently at its lowest level. Every time that we’ve seen Google’s implied volatility this low it has quickly and swiftly moved higher. This can be a good time to buy a straddle that is thirty days out.
Let’s look at another example:
Facebook looks very similar to Google. Implied volatility hasn’t been this low in two years. The odds that implied volatility will increase soon are high. Buying a straddle here can be highly profitable.
What Happens When You Are Wrong?
Just because you stack the odds in your favor, doesn’t mean you are going to win all of the time. Sometimes, implied volatility will stay depressed, and the stock won’t move at all. It happens.
We can use volatility to help ease our losses.
Volatility makes up a large portion of an option’s price. The higher the implied volatility, the more expensive the options will be. You can see this effect during earnings. Days before a company reports earnings, the options will be very expensive because implied volatility is extremely high. (Disclaimer: That doesn’t mean you should short options during earnings. There is a better options earnings strategy.)
On the other hand, if we are purchasing options that have low implied volatility, we are purchasing “cheap” options. Straddles have unlimited profit potential with a limited risk. The risk is limited to the debit you pay when you open the position. Cheap options give you a smaller debit and a smaller overall risk, so if you’re wrong, your losses will be minimal.
Implied volatility can be the hero or the villain in your portfolio.
If you buy straddles when volatility is at its absolute lowest, the odds you will make money greatly increase. If the trade doesn’t work, you’ve kept your debit small which means your losses will be small.
Conversely, if you buy straddles when volatility is at an average level or high, the odds you’re going to make money has been reduced. High volatility means expensive options, and that means you have more risk on the table.
Time your trades properly and you will be able to trade for the long-term. Keep probability and risk and reward in your favor.