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Option investors have a unique ability to profit in the market no matter which direction a stock’s price moves. A straddle is a great example of this kind of strategy.
A straddle is market neutral, which means that it will work equally well in bear or bull markets. These trades have an extremely low probability of maximum loss and can earn big returns if a stock’s price moves a lot.
Sometimes stocks move a lot unexpectedly, and other times we can predict this volatility. One of these predictable periods of volatility immediately follows earnings announcements. These happen every quarter and the news can affect a stock’s price dramatically. (Get 12 Keys to Trading Earnings for Profits.)
In the accompanying video we will use a specific case study for using an option straddle the day before a Google (GOOG) earnings release.
In order for a straddle to be successful, a stock’s price needs to make a big move up or down. The “straddle” means that you are buying two options, a call and a put, with the same strike prices. Imagine that you are “straddling” both halves of the option chain sheet. A straddle is most frequently entered with the at-the-money strike prices.
In this example, GOOG was priced at $390 per share and the 390 strike price calls and puts cost a combined total of $45 per share, or $4,500 total to purchase one contract.
If we imagined holding the straddle through to expiration the stock would have to move at least $45 one direction or the other to reach breakeven. Although this article is about short-term straddles, sometimes buying a straddle with a long expiration date can be an effective strategy. (Learn more about long-term option straddles.)
This may sound a bit unusual to buy both a call and a put at the same time. New traders often assume that gains from one of the options will be offset by losses in the other. That is true to a point; however, eventually the losses from the losing option will be outpaced by the gains from the winning option.
For example, imagine that the stock breaks out to the upside; the call will begin gaining in value while the put loses value. As long as the call gains more than the put, the straddle will be profitable.
That is also true in reverse if the stock begins to lose value. Because both options are long, they can only lose what was originally invested, while the winning side still retains the possibility of unlimited profits.
Because such a large move is needed to become profitable, it is more likely that the trade will conclude with a small loss. However, because the upside potential for long options is theoretically unlimited, a straddle trader is counting on the much larger wins to offset the more frequent losers.
