If you thought a stock was going to break higher due to an upcoming earnings announcement or major piece of news, you could use a number of strategies to profit.
For example, you could simply buy the shares outright and close out the position after the stock rises.
Another strategy is to buy a call option. A call option typically increases in value when the underlying stock rises.
It becomes more difficult, though, when you are expecting a breakout… But you’re not sure which direction it will go.
Covering Both Sides
One way options traders deal with this scenario is with a strategy called a “straddle.”
A long (or bought) straddle is where you buy an at-the-money (ATM) call option and an ATM put option on the same stock with the same strike price and expiry date.
An ATM option is exactly what the name implies. The option’s strike price is the same, or as close as possible, to the underlying stock price.
To see how it works, let’s consider an example using Netflix (NFLX). Please note that this is not a trade recommendation.
If NFLX is trading at $375, that means buying a NFLX $375 call option and a NFLX $375 put option both with the same expiry date.
That’s why it’s called a straddle.
You have an option leg on either side of the stock price. This means you have a foot in both camps.
Note that you need to buy both options at the same time.
At first glance, a straddle might seem like a no-brainer. That’s why it’s popular with option traders.
After all, it looks like you benefit whether NFLX rises or falls.
That’s because the call option captures the upside while the bought put benefits if NFLX falls.
Yet although this strategy may look good on paper, turning a profit is more challenging than it seems.
Time Is Critical
The primary reason for this is that you are paying two option premiums…
That means you’re dealing with time decay for both legs of the trade.
The trade also has to become profitable enough to make up for the cost of those two premiums combined. That means the underlying stock has to move significantly (in either direction). And that has to happen before it expires for you make money out of the trade.
Let’s go back to our NFLX example.
If our call option and put option cost $25 each (with an expiry around 50 days out), that means we have to recoup $50 before we break even on the trade.
If NFLX is currently trading at $375, it will have to rally above $425 before it expires ($375 plus $50) for us to make money.
Alternatively, it would have to fall below $325 by the expiry ($375 minus $50) for us to make money on the downside.
As you can see on the NFLX chart below, that is a big move in either direction. And it has to happen in a short amount of time.
Netflix (NFLX)
Source: eSignal
With the clock ticking down to expiry, we could run out of time before the move occurs (if it happens at all).
That’s why buying a straddle purely in hopes of a big move can be a low-probability way to trade.
And that’s why you need to fine-tune this strategy.
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It’s About Volatility
The key ingredient that some option traders miss is volatility.
Volatility plays a massive part in how options are priced.
The more that market makers and traders expect the underlying security to move, the more they will pay (option buyer) or receive (option writer).
Think about it from the market maker’s perspective…
If they’re expecting volatility to increase (meaning bigger price swings), then the probability is higher that their option will be exercised.
They’ll want to be compensated through higher option premiums for writing (selling) that option.
That’s why, when you buy a straddle, the goal is to buy when volatility is low but increasing. And then you want to sell when volatility is high.
Doing the opposite can quickly tear up your position.
So while some folks might see long straddles as a bet on future price levels, professional traders see them as a “long volatility” trade.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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