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Options Straddle Trading

When a trader expects a large market move, but is unsure of it’s probable direction, a straddle may be bought. When volatility is low or when there is also the case of an “even-driven straddle”, such as before earnings announcements or before an FDA meeting, the strategy is usually applied. The market may not be flat and volatility may actually be very high, in such cases.

In order to straddle buy, both a long call and a long put on the same asset, identical strike prices and expiration dates are used. There is an unlimited profit potential for the call option and a large profit potential for the put, if the market makes a major move before the options expire. Concurrently, the maximum potential loss remains limited to the total premium paid for the two options positions (plus commissions).

Technical indicators may conflict with each other, in a flat market particularly. Flat markets ultimately resolve with an explosive move in one direction or another quite commonly; it is not always possible however to anticipate in which direction the breakout will occur. Provided the market moves quickly enough and far enough, a trader who buys both call and put options may thus be able to profit from such a situation. While one option may then appreciate quickly in value, the other can often be liquidated at a small loss; be aware however that time erosion works against the straddle buyer. Whilst the trader is staying in a position in anticipation of a major market move – during which the market stays flat and exhibits low volatility – the time value of both puts and calls erodes constantly.
To buy at-the-money or close-to-the-money puts and calls is a good strategy. To invest equal amounts into puts and calls (doing otherwise would imply a market bias – either bullish or bearish) is also desirable. To give yourself enough “time to be right” (i.e., for the market to make its move), buy puts and calls with at least 3 months to expiration. Do not remain in straddle too long, as time works against the option buyer, incase a rapid move of the underlying not materialize.

A word about the cost of this strategy: You are incurring commissions on two separate option transactions, because you are buying both puts and calls. The cost of buying a straddle is therefore quite high.

Summary of the straddle buying strategy: A straddle buyer may lose money because of the time erosion associated with the position , if the underlying stays in tight range (flat market) and does not break-out strongly and quickly. The trader can quickly liquidate the losing side of the trade (thus minimizing losses) while maintaining the winning position (which has the potential to bring considerable profits) if the market makes a major break-out soon enough.

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