Learn how to implement a straddle options strategy. Utilize this strategy when you expect a large price move in a stock or ETF, in either direction. By George Papazov.
Volatility is what causes investors to lose sleep; they toss and turn in bed feeling helpless while their portfolio gyrates up and down like a theme park roller coaster. This year has been a prime example. On the flip-side, volatility is the dream of the trader. We don’t care where the market goes, as long as it goes somewhere.
I will share one of my favorite volatility-based trading strategies using options. It is very easy to implement, cost-effective, and the profits can be triple baggers (300% +).
Market Conditions for Successful Implementation
First of all, it is important to recognize that this strategy is very profitable when you are expecting a significant move to happen in the market over the next few days to weeks.
You do not want to use this strategy if a massive move has already happened, or a massive news event has already been priced in. Options are already very expensive, stay away from long premium trades in these situations.
My personal tip: I love to use this strategy when we are at or near all-time highs or big resistance, because you know there will be some large positions being entered into or exited, which can cause an imbalance that leads to a big move.
The Straddle Options Strategy
Implementing this strategy is relatively simple. It involves purchasing two options.
1. Long one call option with strike nearest to current market price
2. Long one put option with same strike as the call above
For a mini-crash course on what what call and put options are, see Debit Spread Options Trading Strategy.
The Trade Setup and Implementation for Straddle Options Strategy
First, I should mention that I love this strategy on index options and index ETF options. SPY, QQQ, IWM, GLD and DIA are my favorite.
The ETF that tracks the S&P500 is “SPY”. The current market price is $213.40 as of the July 11 close.
I believe the next 30 days will bring significant volatility that will either continue to press prices to new highs, or sellers will take control and this breakout will fail once again. I don’t know where price will go, but I don’t care, I just need it to move in one direction.
Step 1) Pull up August 12th option chain for SPY (30 days out).
Step 2) Choose the strike price closest to $213.40 market value, which is $213.50 in this case.
Step 3) Purchase the 213.50 Aug 12th call option for $277 per contract ($2.77 x 100 shares/contract).
Step 4) Purchase the 213.50 Aug 12th put option for $281 per contract.
Total cost = $277 + $281 = $558 for both contracts.
If you want to do 10 contracts, it will cost you $5,580. From here, it is all about scaling to your comfort and making sure you are risking 1% to 2% maximum (of your trading account capital) for any given trade.
When Do You Make Money with a Straddle
Because the cost to buy directional exposure to the upside and downside is a total of $558, or $5.58 per contract, you need the SPY ETF to move at least this much in either direction within 3o days to break even.
This is a 2.6% move ($5.58 / $213.40). This shouldn’t surprise you, as you are expecting a big move to happen before choosing this strategy. If you do not think SPY will move more than 2.6% in the next 30 days, you cancel the trade and move to the next opportunity.
Here is the profit/loss diagram for the trade above:
Notice that you need price to move above $218.98 to make money to the upside OR below $207.82 to make money to the downside. The dotted line is the profit or loss on the expiry date, 30 days from now (Aug 12th). The solid line is the price as of now, July 11th. The solid line will eventually turn into the dotted one, as time passes.
Another way to look at the straddle is:
1) If prices increase far enough, the call option gains will make up the losses for the put, and then some.
2) If prices decrease low enough, the put option gains will make up the losses for the call, and then some.
When Do You Lose Money with a Straddle Option
You will lose the most money if the SPY ETF does not move at all and stays at the exact same price you initiated the trade by the August 12 expiry date.
This is because the call option and put option premium will essentially expire worthless. This is called theta burn or theta decay.
If prices move up or down less than 2.6% before expiry, you will have a partial loss. You can look at the diagram above and approximate how much that loss will be by looking at the Y scale on the graph.
The maximum loss you can incur with this options strategy is what you paid to initiate the trade. This will only occur if markets don’t budge for 30 days, or goes up 5%, only to drop and finish where they started by expiry. The maximum loss happens very rarely with this strategy (in 14 years, it has only happened to me 2 times!).
Risk Management Best Practices for Options Straddles
The most important part of any professional traders plan is how they manage risk.
Here are 4 rules I follow very strictly when trading straddles.
1) I close my trade when I lose 30% of my premium. At this point I was wrong, the market isn’t moving fast enough. I’m out. So in the above example, if straddle drops below $558 x 0.70 = $390.6, I cut my loss at -$167.4.
2) Alternative, I will close 50% of my position when I reach 30% profit, another 25% of my position at 60% and I’ll leave the remainder at break even until expiry. If you only trade 1 contract, then consider taking profits at some point. Never let a winner turn to a loser, ever!
3) Never buy straddles within 30 days of an earnings event or news release – the premium is already expensive by that point.
4) Buy earnings straddles 40+ days before earnings on FANG stocks (FB, AMZN, NFLX, GOOGL).
Converting a Straddle Into a Directional Trade
The beauty of any options strategy is that once you initiate the trade it can be molded to something different if your bias and expectations change, and they will.
Let’s assume you start with the straddle above, but:
1) After a 1% move up, you believe the market is going to trend higher. Sell your put option and just hold the straight call.
2) After a 1% move down, you believe the market is going to trend lower and sell off quickly. Sell your call option and just hold the straight put
Just remember, if your bias changes and you alter the strategy, your profit and loss will change. Directional trades are riskier because you are making a bet on where prices will go. The straddle just makes a bet that they will go somewhere. That is a huge difference. You should always know when, where and why you will get out before you get in or adjust.
Conclusion for the Straddle Options Strategy
The straddle is a great strategy to have in your tool belt, especially when markets start making big moves. This strategy is especially helpful near support or resistance, as the supply and demand imbalances will send the market to the next target level, which can generate some windfall profits.
Good luck and good trading, and remember to demo trade any new ideas before implementing them in your live account.
If you are interested in learning more about options trading, and how to utilize options effectively in all market conditions, check out my free 14-day unlimited trial. You get access to over 40 lessons, 3 courses, workbooks, a strategy selector tool and more. Claim your 14-day trial here: www.tradeproacademy.com/freetrial
By George Papazov
George Papazov has over fourteen years of trading experience in currencies, stocks, futures and options. In 2012, he founded TRADEPRO Academy to offer traders a complete development package.