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With the election today and the Fed’s meeting kicking off tomorrow, this week is shaping up to be highly volatile.
If that has you biting your nails, I’m sure you’re not alone… especially when looking at your portfolio.
How do you trade when a major breakout could be in the cards… but you don’t know which direction?
Today, I want to run through an options strategy that can help in these moments.
So, let’s check out what’s involved…
Expecting a Big Move
If you’re confident in a stock’s direction, you can simply buy an option. You buy a call option if you think the stock will rally… or a put option if you think it’s going to fall.
But when you are expecting a breakout without a clear direction, you might not know what to do.
One way traders deal with this scenario is a strategy called a “straddle.”
In simple terms, you buy a call option and a put option on the same stock at the same time.
You use the same strike price and expiry date for both options.
And critically, you use at-the-money (ATM) options. In other words, both options’ strikes are as close as possible to the price the stock is currently trading at.
That may seem confusing. So let’s check out an example… (Please note that this is not a trade recommendation.)
How to Use a Straddle
The Invesco QQQ Trust Series 1 (QQQ) is trading around $490. You think it could break out strongly in either direction – but you’re not sure which way.
So you decide to buy a straddle…
That straddle involves simultaneously buying a QQQ $490 call option and a QQQ $490 put option with the same expiry date.
That’s why it’s called a straddle… You have a foot on both sides of the trade – bullish and bearish.
At first glance, a straddle might seem like a no-brainer. It looks like you can benefit whether QQQ rises or falls.
The call option captures the upside… and the put option should benefit if QQQ falls.
But the setup has to be just right to turn a profit…
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You Need a Big Move
The downside of a straddle is that you are paying out two option premiums. So to make money, you first have to recoup those upfront costs.
Let’s go back to our QQQ example…
If our call option and put option cost $20 combined, we need to recoup that $20 before we break even on the trade.
(Keep in mind that options contracts involve 100 shares, so that means this straddle position would cost $2,000 in total.)
In general, here’s what that means…
If QQQ is currently trading at $490, it will have to rise above $510 ($490 plus $20) before expiry for us to make money from a QQQ rally.
Alternatively, QQQ would have to fall below $470 ($490 minus $20) by expiry for us to make money from QQQ falling.
That’s a substantial move in either direction, especially in a short time… You can see a visual on the chart below:
Invesco QQQ Trust Series 1 (QQQ)
Source: e-Signal
With the clock ticking down to expiry, we could run out of time before the big move comes off.
So before rushing out to buy a straddle, you need to consider an essential ingredient of the strategy…
It’s All About Volatility
Volatility plays a massive part in how options are priced.
The more stocks swing about, the more that increased volatility gets factored into options premiums.
So when you buy a straddle, the goal is to buy when volatility is low… but increasing. Then you want to sell when volatility is high.
The other key thing to remember is that increasing volatility increases the value of both call and put options.
Say that QQQ rallies strongly or falls heavily, for example. The combined value of our two options could increase to $25 or $30 just from that increase in volatility.
So you could close out the trade for a healthy profit no matter what direction QQQ takes.
Understanding volatility is key to getting this strategy to work.
Some folks might see straddles as a bet on future price levels. But professional traders view it as a bet on volatility.
So as we head into the coming week, keep an eye on volatility… and make sure you have this options strategy in the back of your mind.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict