Straddle Strategies in Option Trading

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.

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!

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.

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.

Steven is the webmaster of http://www.option-trading-guide.com If you would like to learn more about Option Trading or Technical Analysis, do visit for various strategies and resources to help your stock market investments.

---

Raising Capital Using a Public Company

Going public in this manner is ideal for companies that may not be large enough to attract an underwriter for an IPO and those that don't need... Read More

Creating Wealth by Gearing Up

Gearing is where you borrow money to invest. As already mentioned, it is best to clear all your debt before looking at investment. However, there will arise... Read More

The Perfect Economy?

The U.S. economic data reported this week showed strong output growth with tame inflation. Industrial Production expanded at about 1% in June, three times greater than expected,... Read More

How to Invest Overseas - Intelligently!

In recent months, many advisors have talked a lot about the wisdom of investing overseas, but most have failed to really address the way to do that.... Read More

Dumb Money

Many people have, at one time or another, taken some of their hard-earned funds, and decided to put them in the stock market. These well-meaning individuals either... Read More

Will a Falling Dollar Derail Your Plans for Retirement?

How much are you willing to pay for a tank of gas? We've all watched as gas prices hit record highs, but what would you do if... Read More

Foreign Investing - US Investors Still Missing Out?

Investors are still too slowly realizing what the academics have long pointed out ?- adding foreign stocks to your portfolio will, over the long term, increase your... Read More

Have You Ever Seen A Map of the World Turned Upside Down?

For those accustomed to viewing things a certain way, it is quite disconcerting. One almost expects the ocean to pour out. It just seems wrong. Yet, the... Read More

Profitability And Stock Turn Rate

The inventory of the typical store represents the largest single element of its total assets. The sale of goods from this inventory is the merchant's chief source... Read More

Begging Your Trust in Africa

The syntax is tortured, the grammar mutilated, but the message - sent by snail mail, telex, fax, or e-mail - is coherent: an African bigwig or his... Read More

Index Trading Weekly Update

Here is a sample of the last newsletter:SP500 Last Signal Comment We just had a new sell signal last friday on june 10th 2005. As expected... Read More

Numismatics are for Collectors, Not Investors

As a precious metals investor, you may heard much about numismatic and "semi-numismatic" coins, particularly the St. Gaudens $20 double eagle gold coin. While coin collecting can... Read More

An Old Dividend Stock Investment Idea, for a New Generation

Death and taxes! The certainties of life! And then, of course, there are the mortgage payments, the utility bills, phone bills, the car payments and thirsty automobiles.... Read More

Investing in Car Dealerships: Doing Your Homework

This article attempts to help give the investor a broader basis upon which to decide whether a dealership merits their time, money and attention.Interviewing Factories and Financial... Read More

Just what is Arbitrage Investment?

In the simplest of terms, Arbitrage means to exploit price differential.Usually it meant looking at differing sources of an investment, and if there was a price difference... Read More

Trading For A Living - Part 2

In part 1 of this article I started to look at the financial implications of giving up the day job to instead start trading full time for... Read More

Types of Investment

The word 'investments' is one that most of us are familiar with hearing in financial context. For many of us, it may make us thing of big... Read More

Stocks: Reduce Risk Yet Maximize Profits

It is important to note that every smart investor wants to minimize risk while maximizing profit potential. Yet conventional investment theory tells us that in order to... Read More

Fundamentals of Option Pricing

When one begins to consider an option, it is very important to figure out how the premium is calculated. Option premiums depend on a variety of factors... Read More

Investor Guide to Financial Health

Step 1: Spend less than you earnPerhaps the simplest financial concept is the toughest for us to conquer- spend less than you earn. After paying your living... Read More

Retire Dollar Smart

Jim Miller is a registered investment advisor. This means that he is not beholden to a particular brokerage or financial institution. As such, he does not charge... Read More

Larry, Moe and Curley, Investment Brokers

Larry, Moe and Curley were sitting in their favorite restaurant just off Wall Street having their usual 3 martini lunch and were discussing the day's events and... Read More

The Realities Of Market Timing

Market timing systems are based on patterns of activity in the past. Every system that you are likely to hear about works well when it is applied... Read More

Consolidation Period

The economic data reported Fri showed continued above trend growth with disinflation (at the core level, excluding food and energy) in the second quarter. Real output growth... Read More

Stock Market Retirement Investment Plan

For a successful retirement investment plan to work in the stock market, some 'reasonably sure' assumptions would have to be made:The retirement investment plan must take into... Read More

Asset Allocation Lessons: The 70% Inflation Solution

For investors only... and for speculators who need to invest their winnings.Lesson One: Asset Allocation is an Investment Planning Tool, not an Investment Strategy... few investment professionals... Read More