Conquering the Notoriously Difficult Straddle Play

by Tyler Craig | March 27, 2012 8:41 am

The recent action in Amazon.com (NASDAQ:AMZN[1]) offers a prime example of the risk-reward payoff for the notoriously difficult long straddle play[2]. In an attempt to attract others to their ranks, straddle acolytes possess a number of seductive, yet slightly misleading, tag lines. Take the following, for instance:

“You win whether the stock moves up or down!”

The trouble with this assertion is that it oversimplifies how the strategy accumulates profits. Such a mischaracterization leads the well-intentioned masses into thinking the straddle is practically a sure thing, when in reality it resides in a different hemisphere altogether. (And after all, there is no sure thing in the world of investing, options or otherwise).

To those otherwise unfamiliar with the main character in our tale, the elements of a long straddle strategy are two at-the-money options, one call and one put, that expire in the same expiration month. The position is considered a bi-directional, long volatility bet.

Contrary to popular belief, it does not win whether the stock moves up or down. Rather, it wins if the stock moves up or down more than is expected. Sadly, the options market isn’t run by dimwitted ignoramuses. It’s an efficient monster with a voracious appetite for any free lunches that might be lying around. With regards to straddles, this means they will often be accurately priced, making their purchase anything but a slam dunk.

Purchasing a straddle isn’t so much a bet that the stock is going to rise or fall a large amount, but rather that the stock is going to rise or fall more than the options are already pricing in via volatility and other factors. It’s the expression of an opinion that the marketplace has it wrong. Unfortunately, consistently identifying the mispricing of straddles is easier said than done. The difficulty of such a task explains, in part, why long straddles aren’t as frequently used as other strategies such as vertical spreads.

In the end, long straddles should be used sparingly in the somewhat rare situations where the efficiency monster has left a free lunch or two lying around. While there aren’t any guarantees, your straddle success can be increased by looking for scenarios where implied volatility is cheap and the underlying stock appears poised for a strong move.

The recent symmetrical triangle in AMZN coupled with its multi-year low in implied volatility represented the ideal scenario for straddle buys. The stock’s breakout — AMZN has advanced more than 9% in the last five days — and subsequent pop in implied volatility nicely demonstrated the potential reward available to those prescient enough to jump in just prior to the breakout.

Screen Shot 2012 03 27 at 7.28.08 AM 300x221 Conquering the Notoriously Difficult Straddle PlayClick to Enlarge

At the time of this writing, Tyler Craig had no positions on AMZN.

Endnotes:
  1. AMZN: http://studio-5.financialcontent.com/investplace/quote?Symbol=AMZN
  2. long straddle play: http://investorplace.com/2011/04/options-strategies-long-straddle/

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