Straddling Strategies for Options Trading Explained
One of the most used strategies in trading options is Straddling, which is defined as a direction neutral trading strategy.
A Straddle involves the following steps
Purchasing at-the-money strike puts
Purchasing at-the-money strike calls with the same expiration date
This is a net debit transaction as you are paying for an equal number of calls and puts. In terms of cash requirements, the straddle is an expensive strategy. However, if you apply the strategy correctly, it doesn’t feel like a high-risk strategy even if the volatile price action that is anticipated, doesn’t materialize.
This strategy has two breakeven points with one being below and the other, above the strike price. The call and put share the same strike price, which should be as near the money as possible. In other words, it should be as close to the current stock price as possible.
How to find a good straddling opportunity?
There are a number of key considerations that you have to look at find and play a good straddle opportunity.
You should generally avoid stocks priced below $10 for playing straddles. Always remember that you are on the lookout for anticipated explosive price action, which can be in either direction. This requires you to have enough room on the downside to have a profitable trade in case there is a savage downward movement which increases the value of the put.
Consolidation patterns such as flags, pennants and triangles offer visual clues of declining historical volatility. Additionally, you should also investigate whether the implied volatility is also declining. Consolidation patterns often come before a breakout of some sort, which is precisely what is needed by a straddle trade to work. With straddles you should be interested in explosive price movement rather than direction, once you place the trade.
Implied volatility and historical volatility
Ideally, for a straddle trade to work, you would need a scenario where the current implied volatility for the stock is low compared to its average implied volatility over the medium term (three months to one year). The scenario you would ideally want is the implied volatility being lower than the historical volatility over a 1 month, 2-month, and 3-month period.
There are some stock option chains that contain price series, which consistently reflect implied volatility as being greater than historical volatility and the other way around. This is why you should compare implied volatility to itself instead of historical volatility over different time frames to get a clear idea of whether implied volatility is too high or not.
Some other signs include taking a look at the wider market and the specific sector of the stock to assess whether it is poised for higher volatility. You can do this by taking a look at the Market Volatility Index which is measured from the S&P 100 index. You should also examine price charts to see whether any signs of consolidation exist in the price pattern.
After identifying a stock that is consolidating, you have to first determine whether there is any news anticipated on the particular stock. Earning reports or other anticipated new items such as CPI, PPI, GDP, and employment reports from the government should be considered. The aim should be to place the trade just before the announcements are made as it is considered as a catalyst for the explosive move you are looking for. You should place your straddle trade ideally a week or so before earnings. This is because implied volatility often starts rising as earnings season approaches.
Time to Expiration
Give yourself enough time to be correct. However, you should not take so much time that it becomes difficult to make a profit because of the rising options premiums. You should trade straddles with expirations about three months out. This is due to the time value decaying at its fastest one month before expiration. You would want to exit your position with at least one month till expiration at the latest, regardless of price moves.
Always look to minimize the risk, which in this case is time decay. If the stock prices don’t move after you have placed a trade, the risk is still low provided that you don’t leave it too long. The only exception should be if implied volatility plummets suddenly through the floor, which also drags down options premiums simultaneously. Trading three-month options for the straddle is a good idea as they are less sensitive to implied volatility surge and dump, compared to one-month options.
While playing a straddle and anticipating a new event such as a company announcement or earning report, exit quickly if there are no surprises. This minimizes your risk exposure significantly, especially if you were in anticipation of a surprise. Thus the time to expiration can be anywhere between 2 to 4 months. Whatever happens, you should always look to exit the trade with more than a month left to expiration if there has been no movement.
Exiting a straddle play consists of a number of scenarios as mentioned below.
After a news announcement where there is no price movement because of a lack of surprises, always look to exit within a couple of days where the lack of price movement confirms the lack of surprise.
In case of a news announcement where there was a surprise and the requisite price movement, you can play this scenario in a number of ways. You can either sell the profitable side after a price move and keep the unprofitable side in anticipation of a price retracement the other way, after which you can sell that side too.
Another strategy involves keeping the profitable side and managing it by way of a trendline to benefit from any continuing move. At some point, the trend line will break after which you will take your profits. If the move continues for some time, it can be considered a potential windfall.
While trading stocks, it may so happen that you are unsure about the direction the price of the stock will take, but you are sure that it will move significantly in one direction or another. In such a scenario, trading options will give you the ability to make low risk-high reward without getting the direction right.