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Learn to Trade Options: The 'Sweet Spot' for Straddles and Strangles

Schaeffer's Senior Trading Analyst Bryan Sapp offers a trader's take on how (and when) to play long straddles and strangles

Oct 16, 2015 at 2:19 PM
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    While call options are usually associated with bullish bets, and put options are associated with bearish positions, long straddles and strangles are hybrid strategies that allow traders to bet on a big move in either direction. By purchasing both calls and puts on the same stock, speculators can profit on a significant decline or rally -- an enticing trade during earnings season

    With that in mind, I sat down with Schaeffer's Senior Trading Analyst Bryan Sapp -- our in-house volatility expert -- to get a trader's take on how (and when) to best employ these strategies. But first, the basics.

    The primary difference between a long straddle and a long strangle is strike price. To initiate a long straddle, a trader would simultaneously buy to open a call and put on the same stock, at the same strike, with the same expiration date. The position will make money if the underlying either plummets beneath the lower breakeven rail (strike minus net debit) or skyrockets north of the upper breakeven rail (strike plus net debit) within the options' lifetime. Potential losses, meanwhile, are limited to the initial premium paid.

    To initiate a long strangle, the trader would simultaneously buy to open a call and put on the same stock, but at different strikes in the same series. Typically, both options will be out of the money. Again, there are two breakeven points: the put strike minus the net debit, and the call strike plus the net debit. The worst-case scenario is for the stock to remain relatively stagnant through expiration, at which point both options will remain out of the money, and the speculator will swallow the entire premium paid at initiation.

    Got all that? Here are Sapp's words of advice for potential volatility traders:

    • What are the advantages of buying both calls and puts on the same stock? When purchased "properly" -- i.e. when implied volatility is relatively cheap -- straddles and strangles can have the added benefit of being big winners when you're dead wrong on the direction of the trade. An added benefit to strangles is you can pre-define your risk when entering the trade by calculating your maximum loss, and that helps control your risk within a portfolio context.
    • Is there an ideal environment or stock backdrop for straddles and strangles? Generally, any time implied volatility is low on a stock or exchange-traded fund (ETF) and there's a potential catalyst in the near future. Oftentimes, if you identify a significant catalyst and purchase options when implied volatilites haven't spiked ahead of that catalyst (earnings, investor day, Fed meeting, jobs report, etc.), you can get a "free ride" into that catalyst, since implied volatility in the stock's options will gradually increase into the event. I’ve found this "sweet spot" ahead of major catalysts to generally be 7-10 days. 
    • What do you look at before you initiate a volatility play? Any particular indicators? The three things I look for before entering a volatility play are: 1) option prices (i.e. relative implied volatility); 2) a potential catalyst; and 3) a chart pattern that looks ripe for a break. I like using Bollinger Bands as an indicator  -- when they’re "pinched," and near an extreme low, that could be a sign that the equity or ETF could be ready to make a big move. By nature, volatility is mean reverting, so long periods of no volatility are generally met with some extreme volatility on the other side. Contrarily, it's generally not a good idea to buy straddles or strangles on instruments that are in a volatile period. Not only do those equities have a tendency to "chop" after a volatile period, but also options will be relatively expensive.
    • Give me an instance when you'd initiate a straddle over a strangle, and vice versa: It all comes down to directional bias. Many times, the best straddle trades will happen when you have no directional lean and the stock is at a critical inflection point in it price. By this, I mean that the stock or ETF may be a price that's served as both support and resistance multiple times in the past. Strangles can be effective when the trader has a directional lean, but also wants to hedge that bet and limit risk.
    • What are the ideal contracts for these spreads? Short-term? Long-term? Weekly? LEAPS? This generally depends on the time frame of the trade catalysts and also the volatility term structure. Depending on the expiration date of the options, they will be priced differently because of different perceived implied volatilities over time. For example, an option that expires right after a company is set to report earnings will generally be more expensive than an option that expires a month ahead or behind its earnings report. With option pricing, it's market-driven and all about perceived future volatility. Whenever I'm playing ahead of a catalyst, I generally prefer to buy an extra month or week (if it’s a short-term straddle trade on an instrument that has weekly options) beyond that catalyst. The reasoning for this is both the stock or ETF will have more time to continue its move after the catalyst, and also implied volatility will almost always be relatively cheaper further out on the volatility curve. 
    • When should traders avoid straddles/strangles? Generally, the summer lull and around holidays are bad times to be buying volatility. This isn't always the case, but more often than not. Also, it’s generally a bad idea to buy double premium immediately ahead of an event (like the day of earnings), as implied volatility is generally at its highest and options are the most expensive at that point in time.
    • As far as trade management, what do you do differently, if anything, for a straddle/strangle vs. a traditional call or put purchase? Not a whole lot. With straddles, I always want to enter a situation where the profit potential is at least 100%, since that's what you have at risk. Granted, straddles will very rarely finish as a total loss, but you certainly want to avoid a situation where you're hoping to make less than a double of the initial investment. I've found the best way to identify targets on straddles is by looking for key support and resistance areas around the current price, and use the straddle price to determine if a move to either of those levels will produce a 100% return. Also, if using an earnings report on a stock as a catalyst, make sure that stock actually moves on the numbers, historically. Some stocks are extremely volatile on earnings, and some others will rarely move. Make sure you're getting the potential for big volatility, if that's what you’re paying for. If those two things don't align, then move on to the next trade idea.

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