In increasingly turbulent times, it is imperative to know how to profit from volatility. One strategy that is designed to profit from such volatility is the straddle. Straddles work well when large price moves are expected. A straddle is comprised of long call and long put options, both purchased at the same strike price and typically in the same expiration month. The strategy requires substantial stock movement in order to profit.
Let's assume XYZ stock is trading at $40 per share. And let's further assume that long call and long put options are purchased at strike $30, and each option costs say $3.00 per share for a total net debit of $6.00 per share. Assuming the trader holds both options until expiration, one of the options must be worth $6.00 for the trader to reach a breakeven point.
If the stock rises to $46 per share, the long call option will have an intrinsic value of $6.00 (profit of $3) and the long put option would expire worthless, resulting in a loss of $3.00. The net result is a breakeven trade. The stock would need to drop to $34 in order for the long put option to have $6 of intrinsic value upon expiration. The long call would expire worthless, resulting in a $3 per share loss. So, in this example a $6 price movement is needed to breakeven which is equivalent to a 15% stock move.
Once a trader knows how much movement is required to breakeven, due diligence begins. As we stated earlier, straddles are employed to take advantage of a violent stock movement that is expected to occur in the very near future. Some events that may cause a stock to move violently include an upcoming earnings report, an FDA announcement, an end to litigation, a potential merger or a macroeconomic event. Straddles can be purchased hours, days, weeks or even months before an event. Typically, if a trader knows when the 'news event' may occur, the trade can be purchased a few days ahead of time in order to avoid overpaying due to the price of the options rising as the event approaches.
Since a straddle involves purchasing two long options, which will be affected by time and volatility decay, it is of supreme importance that due diligence is conducted before entering the trade. Straddles often provide instant gratification when a news event is released. Unfortunately, anticipated gratification can quickly turn to discontent since both options could lose 20% or even 50% if sufficient stock movement is not realized. It is of paramount importance to use proper risk management techniques. Note this is typically not the type of trade that an investor places a substantial percentage of a portfolio at risk!
Straddles can be extremely profitable trades but are accompanied by commensurate risks. At MarketTamer.com we will show you how to place yourself in the best position to win while factoring in all the pitfalls of the trade. Join a proven, dedicated and winning team at MarketTamer.com.