Market moving news, like elections and central bank moves, has the potential to create market volatility. When you aren't sure which direction a stock is going to go, but you are expecting a big move, you may want to consider an options strategy known as the straddle.
Getting to know straddles
You can buy or sell straddles. In a long straddle, you buy both a call and a put option for the same underlying stock, with the same strike price and expiration date. If the underlying stock moves a lot in either direction before the expiration date, you can make a profit. However, if the stock is flat (trades in a very tight range), you may lose all or part of your initial investment.
Here are a few key concepts to know about straddles:
- They offer unlimited profit potential but with limited risk of loss.
- The more volatile the stock or index (the larger the expected price swing), the greater the probability the stock will make a strong move.
- Higher volatility may also increase the total cost of a long straddle position.
- Compared with other options strategies, the upfront cost of a straddle may be slightly higher because you are buying multiple options and volatility is typically higher.
The concept behind the long straddle is relatively straightforward. If the underlying stock goes up, then the value of the call option increases while the value of the put option decreases. Conversely, if the underlying stock goes down, the put option increases and the call option decreases. While it is possible to lose on both legs (or, more rarely, make money on both legs), the goal is to produce enough profit from the option that increases in value so it covers the cost of buying both options and leaves you with a net gain.
What to look for before making a long straddle
Our focus is the long straddle because it is a strategy designed to profit when volatility is high while limiting potential exposure to losses, but it is worth mentioning the short straddle. This position involves selling a call and put option, with the same strike price and expiration date. This nondirectional strategy would be used when there is the expectation that the market will not move much at all (i.e., there will be low volatility). With the short straddle, you are taking in upfront income (the premium received from selling the options) but are exposed to potentially unlimited losses and higher margin requirements.
Diving into a long straddle
With a basic understanding of how this strategy works, let's look at specific examples. Please note that before placing a straddle with Fidelity, you must fill out an options agreement and be approved for options trading. Contact your Fidelity representative if you have questions.
In our example, we will look at a hypothetical scenario for XYZ Company.
In August, you forecast that XYZ, then trading at $40.75 a share, will either rise or fall sharply based on an earnings report that is set to be released in a week. Due to this expectation, you believe that a straddle would be an ideal strategy to profit from the forecasted volatility.
To construct a straddle, you buy 1 XYZ October 40 call for $2.25, paying $225 ($2.25 x 100). We multiply by 100 here because each options contract typically represents 100 shares of the underlying stock. At the same time, you buy 1 XYZ October 40 put for $1.50, paying $150 ($1.50 x 100). Note that in this example, the call and put options are at or near the money. Your total cost, or debit, for this trade is $375 ($225 + $150), plus commissions.
The maximum possible gain is theoretically unlimited because the call option has no ceiling (the underlying stock could rise indefinitely). The maximum risk, or the most you can lose on this trade, is the initial debit paid, which is $375, plus commissions. This would occur if the underlying stock closes at $40 at the expiration date of the options.
Let's make use of breakeven here. In this example, the cost of the straddle (in terms of the total price for each contract) is $3.75 ($2.25 + $1.50). Breakeven in the event that the stock rises is $43.75 ($40 + $3.75), while breakeven if the stock falls is $36.25 ($40 – $3.75). With this information, you know that XYZ must close above $43.75 or below $36.25 at expiration to be profitable.
Managing a winning trade
Assume XYZ releases a very positive earnings report. As a result, XYZ rises to $46.30 a share before the expiration date. Because XYZ rose above the $43.75 breakeven price, our September 40 call option is profitable and might be worth $6.40. Conversely, our September 40 put option has almost no value; let’s say it is worth $0.05.
Before expiration, you might choose to close both legs of the trade. In the above example, you could simultaneously sell to close the call for $6.40, and sell to close the put for $0.05, for a gain of $645 [($6.40 + $0.05) x 100]. Your total profit would be $270 (the gain of $645 less your initial investment of $375), minus any commission costs.
Now, consider a scenario where instead of a positive earnings report, XYZ’s quarterly profits plunged and the stock falls to $33 before expiration.
Because XYZ fell below the $36.25 breakeven price, the September 40 put option might be worth $7.25. Conversely, the September 40 call option is worth just $0.15. Before expiration, you might choose to close both legs of the trade by simultaneously selling to close the put for $725 ($7.25 x 100) as well as the call for $15 ($0.15 x 100). The gain on the trade is $740 ($725 + $15), and the total profit is $365 (the $740 gain less the $375 cost to enter the trade), minus commissions.
Managing a losing trade
The risk of the long straddle is that the underlying asset doesn't move at all. Assume XYZ rises to $41 before the expiration date. Although the underlying stock went up, it did not rise above the $43.75 breakeven price. More than likely, both options will have deteriorated in value. You can either sell to close both the call and put for a loss, or you can wait longer and hope for a sudden turnaround.
Let's assume that with just a week left until expiration, the XYZ October 40 call is worth $1.35, and the XYZ October 40 put is worth $0.35. Since XYZ didn’t perform as expected, you might decide to cut your losses and close both legs of the option for $170 ([$1.35 + $0.35] x 100). Your loss for this trade would be $205 (the $170 gain, minus the $375 cost of entering into the straddle), plus commissions.
The risk of waiting until expiration is the possibility of losing your entire initial $375 investment. Both options could expire worthless if the stock finishes at $40. This is called pinning: The stock finishes at the strike price.
Timing is an important factor in deciding when to close a trade. There are cases when it can be preferential to close a trade early, most notably "time decay." Time decay is the rate of change in the value of an option as time to expiration decreases and, because of that and other reasons, traders might choose not to hold straddles to expiration. Instead, they might take their profits (or losses) in advance of expiration.
In addition to time decay, there are other factors that can influence options used in the straddle trade. Learn about the factors that influence options used in the straddle trade and keep the straddle in your trading arsenal to potentially take advantage of market volatility.