| |
| |
| |
| |
| |
For monthly updates
containing new options trading information and
articles, as well as current technical
analysis trends, subscribe to our Newsletter
below! |
|
| |
| |
| |
"I've always been confused about options trading...
at least now I have a better understanding about it!"
Ben Masters
VIC, Australia
|
|
| |
| |
| |
|
| HOME
> Options Guide > Straddles
and straddle strategy |
Straddles and Straddle Strategy
|
Thus far, we have been looking at basic option
plays, ie. buying either a call or put, and
then either exercising or selling them.
From here on, we will be covering a few more
advanced option strategies that will require
more understanding and experience in trading
options. We recommend that you try trading
or paper trading in the basic options as covered
in the earlier topics before trying the strategies
in the following topics.
We will be covering 3 of the more common option
strategies, but do note that the number of
strategies in use in the stock market by more
experienced traders are plentiful, and are
implemented by various combinations of buying
and selling options as well as the underlying
stock.
|
 |
The option
strategies covered from this topic onwards
are for people who have understood
and tried trading in basic options.
These strategies may become quite
complex. A misunderstanding of a
strategy can result in a huge loss.
|
Straddles
- The straddle strategy is an option strategy that's
based on buying both a call and put of a stock.
Note that there are various forms of straddles,
but we will only be covering the basic straddle
strategy.
To initiate a Straddle, we would buy a Call
and Put of a stock with the same expiration
date and strike price. For example, we would
initiate a Straddle for company ABC by buying
a June $20 Call as well as a June $20 Put.
Now why would we want to buy both a Call and
a Put? Calls are for when you expect the stock
to go up, and Puts are for when you expect
the stock to go down, right?
In an ideal world, we would like to be able
to clearly predict the direction of a stock.
However, in the real world, it's quite difficult.
On the other hand, it's relatively easier
to predict whether a stock is going to move
(without knowing whether the move is up or
down). One method of predicting volatility
is by using the Technical Indicator
called Bollinger
Bands.
For example, you know that ABC's annual report
is coming out this week, but do not know whether
they will exceed expectations or not. You
could assume that the stock price will be
quite volatile, but since you don't know the
news in the annual report, you wouldn't have
a clue which direction the stock will move.
In cases like this, a Straddle strategy would be
good to adopt.
If the price of the stock shoots up, your
Call will be way In-The-Money, and your Put
will be worthless. If the price plummets,
your Put will be way In-The-Money, and your
Call will be worthless.
This is safer than buying either just a Call or
just a Put. If you just bought a one-sided option,
and the price goes the wrong way, you're looking
at possibly losing your entire premium investment.
In the case of Straddles, you will be safe either
way, though you are spending more initially since
you have to pay the premiums of both the Call and
the Put.
|
| |
In a Straddle
strategy, you buy both a Call and a Put
for the same stock, with identical expiration dates
and strike prices. This strategy is good for stocks
where you expect volatility but don't know
which direction it will go. You will
profit whether the stock jumps or falls.
|
Let's look at a numerical example:
For stock XYZ, let's imagine the share price
is now sitting at $63. There is news that
a legal suit against XYZ will conclude tomorrow.
No matter the result of the suit, you know
that there will be volatility. If they win,
the price will jump. If they lose, the price
will plummet.
So we decide to initiate a Straddle strategy on
the XYZ stock. We decide to buy a $65 Call and a
$65 Put on XYZ, $65 being the closest strike price
to the current stock price of $63. The premium for
the Call (which is $2 Out-Of-The-Money) is $0.75,
and the premium for the Put (which is $2 In-The-Money)
is $3.00. So our total initial investment is the
sum of both premiums, which is $3.75.
Fast forward 2 days. XYZ won the legal battle!
Investors are more confident of the stock
and the price jumps to $72. The $65 Call is
now $7 In-The-Money and its premium is now
$8.00. The $65 Put is now Way-Out-Of-The-Money
and its premium is now $0.25.
If we close out both positions and sell both
options, we would cash in $8.00 + $0.25 =
$8.25. That's a profit of $4.50 on our initial
$3.75 investment!
Let's look at this in tabular format:
|
| XYZ |
Day 1 |
Day 3 |
| Stock Price |
$63 |
$72 |
| $65 Call In-The-Money |
Out $2 |
In $7 |
| $65 Call Premium |
$0.75 |
$8.00 |
| $65 Put In-The-Money |
In $2 |
Out $7 |
| $65 Put Premium |
$3.00 |
$0.25 |
| Total Option Value |
$3.75 |
$8.25 |
| Profit |
- $3.75 |
+ $4.50 |
|
Of course,
we could have just bought a basic Call option and
earned a greater profit. But we didn't know which
direction the stock price would go. If XYZ lost
the legal battle, the price could have dropped $10,
making our Call worthless and causing us to lose
our entire investment. A Straddle strategy is more
conservative and will profit whether the stock goes
up or down.
If Straddles are so good, why doesn't everybody
use them for every investment?
It fails when the stock price doesn't move.
If the price of the stock hovers around the
initial price, both the Call and the Put will
not be that much In-The-Money.
Furthermore, the closer it is to the expiration
date, the cheaper premiums are. Option premiums
have a Time Value associated with
them. So an option expiring this month will
have a cheaper premium than an option with
the same strike price expiring next year.
So in the case where the stock price doesn't move,
the premiums of both the Call and Put will slowly
decay, and we could end up losing a large percentage
of our investment. The bottom line is: for a Straddle
strategy to be profitable, there has to be volatility,
and a marked movement in the stock price.
|
| |
Options
have a Time Value associated
with them. The closer they are to
expiration date, the less they're worth.
Therefore, a Straddle will fail
if the stock price doesn't move.
The premiums of both the Call and Put will
slowly decay, and will result in a loss.
|
A more
advanced investor can tweak Straddles to create
many variations. They can buy different amounts
of Calls and Puts with different Strike Prices or
Expiration Dates, modifying the Straddles to suit
their individual strategies and risk tolerance.
This is beyond the scope of this Guide.
|
|
Bookmark
this page
|
|
|
|
