Using Straddles

Exchange Traded options (ETO) can offer the trader some flexible trading opportunities, dependent upon your market viewpoint you can structure option strategies that will make the best of any situation, indeed, many strategies can be adjusted as the trade develops over time.

Today we will outline a trading strategy called a straddle. The concept being that the trader can generate profits as the stock breaks either up or down. This allows the trader to increase profits by making adjustments during the option�s lifetime.

This is a multiple leg strategy and it is important to accept that one of the legs will lose money, although hopefully the other leg makes more than enough profit to compensate.

A Straddle

A straddle is the simultaneous buying of both a Call and a Put option on the same underlying stock with the same strike price and same expiration date.
Straddles allow you to avoid the uncertainty of a stock direction by using stock volatility and option implied volatility of that specific stock, to your benefit.� The profit is regardless of stock direction with unlimited potential gain and limited risk. However,�there are disadvantages, the strategy depends on volatility in the stock price and is affected by time decay. If you are buying a straddle you are hoping for a very volatile movement and if you are writing a Straddle you are expecting the stock price to travel sideways for an extended period.

Writing a straddle

This is known as a short straddle and�is a high risk strategy, maximum profit, which is the total premium earned from the sale of the options, occurs if the share price is at the strike price at expiry. However, if the share price moves sharply in either direction there is the potential for unlimited losses, whilst the net premium received for selling the straddle provides a small cushion, the stronger the move, the greater this loss will be. It is possible to limit the potential loss by buying a put and a call option with out-of-the-money strike prices. The loss is then limited to the difference between the strike prices. This converts the short straddle into a synthetic version of the long butterfly strategy.

Synthetic Straddles

These are slightly different in that they are a delta neutral strategy (Delta: Change in the price of an option relative to the change of the underlying security) and can be created by using calls or puts. The long synthetic call straddle involves short selling the stock and then purchasing call options to create an overall delta neutral position. When the market goes up, the trader will incur a loss on the underlying stock but would have a bigger profit on the options. When the market goes down, the trader would have a profit on the underlying stock and a smaller loss on the options. No matter the direction, as long as the market moves beyond the breakevens the trader will receive a profit.