To The Moon

If you are not familiar with options, I would suggest reading my first 10 posts which can be found under my postings.

Multi-leg Option Strategy: Straddles and Strangles

What are straddles and strangles option strategy?

Straddles and strangles are options strategies that allow an investor to profit from big movement in a stock price, regardless of the direction of price movement.

Both strategy requires BUYING an EQUAL NUMBER of PUT and CALL options with the SAME EXPIRATION DATE.

The difference is that strangle strategy has two different strike prices, whereas straddle strategy has a common strike price. I will discuss strangles in detail in the next post.

When to use Straddle?

Straddle is typically used when there is a potential for the stock price to experience wide fluctuations and the trader is unable to determine which direction the stock price might go. For example, the company is scheduled to release its earnings report in a few weeks time; a good report means the price might shoot up while a bad report means the price might take a dip. Therefore, it will be a good time to execute a straddle strategy before the release of the report to profit from such movement in stock prices. Note that there is no desire to own the underlying stock and there is no need to own the underlying stock with this strategy. This is purely options trading.

How to execute a Straddle?

Each straddle strategy involves a minimum of 2 options contract, 1 BUY PUT and 1 BUY CALL. Every BUY PUT contract must have a corresponding BUY CALL contract. Both PUT and CALL contracts have the same expiry date and same strike price. Strike price selection is typically ATM (At the Money). Duration of the options should not be too long (ideally no more than 1.5 months) The reason is because a longer expiry contract has higher premium, so more upfront cost and less likely to make a profit. Looking at the screenshot below, ATM strike prices are circled in blue. Either one is considered ATM. 

However, we choose the strike price of $132 because it provides slightly lower total premium we need to pay for the PUT and CALL option circled in orange. If we choose $131 strike price, we need to pay a total of ($6.65 + $5.8 = $12.45 per share), which equates to $1245 in total premium paid. This compared to the ones circled in orange ($6.1 + $6.2 = $12.3 per share), which equates to $1230 in premium paid. The idea is to pay as little premium as possible so it will be easier to break-even and profit from the trade.

Calculating Profit and Loss for Straddle Strategy?

Using the above example screenshot, if we take the lower premium paid ($1230), that would be the maximum loss. This will happen when the stock price at the expiry of the contract is between $131 and $133 dollars. This means that both contracts are ATM and expires worthless.

In order to break-even, the price must either rise or fall enough to offset the total premium paid. Assuming we let the option reaches its expiry date, there will be 0 extrinsic value. Only the intrinsic value remains. The intrinsic value is the difference in the stock price and the strike price. This means that the stock must move at least $12.3 dollars in either direction per share to break-even, so the stock price would either be $119.7 or $144.3 on expiry.

In order to profit, the stock must move higher than $144.3 or lower than $119.7 on or near expiry. See the graph below for a better visualisation. 

Note that this is for this example at the time i captured the screenshot. As the market moves, the premium changes. If you calculate by percentage, the stock must either go up or down by at least 9.3% just to break even. To profit, it must move more than 9.3%. Unless the trader is very sure that the stock is that volatile and the stock can move by more than this amount, it would not be beneficial to use the straddle. The trader can also choose to close the options early if the anticipated profit is achieved. There is no need to wait till expiry.

Things to pay attention to when executing a Straddle?

1. Straddle involves a minimum of 2 BUY contracts. This means that the option premium is paid first. Maximum loss will occur when the price stays flat (Both contracts expire worthless ATM). See graph for profit and loss.

2. Both contracts should become valid within a short period of time. Otherwise, the stock price will have moved and the option premium will no longer be the same. This means that there is a potential for the total option premium to increase, resulting in more money having to be paid up front and more difficult to profit. In more extreme cases, the stock price might have moved beyond the ATM strike price, resulting in even higher premium to be paid up front because the option could have become ITM (In The Money) instead.

3. The longer the expiry date, the more expensive the contracts become, and a higher upfront cost. The strategy is typically used when the earnings report release are near or some major announcements are to be made by the company soon. The idea is to pay as little premium as possible so it will be easier to break-even and profit from the trade, therefore, the duration of the options should be no more than 1.5 months.

4. One strategy is to observe the implied volatility of the option. A lower implied volatility means a smaller premium, so traders will monitor the implied volatility and enter a position when the implied volatility is low. Typically, as the company is due to release its earning report, the implied volatility will increase.

In Demystifying Options part 12, I will be discussing Strangles..

Always remember.. If you do not understand what is happening, do not blindly follow and execute the trade!