3 Things You Need to Know Before You Trade a Straddle

Posted on Thursday, April 16, 2020 at 2:13 PM

It’s shocking. Most people simply don’t make money trading straddles—even when things are volatile. Why, you ask? It comes down to just 3 simple factors that are often overlooked by traders. And once you know them, you’ll be a better trader in all situations—especially when expecting high volatility.

How Straddles Work

Straddles are simple—on the surface anyway. Expecting a big move, but not sure of direction? That’s what straddles are for. Buy a call and a put with the same expiration and strike. If the stock goes up, the calls make more than the puts lose. If the stock goes down, the puts make more than the call loses. Win-win. Brilliant!

But here’s the rub…

The 3 Things to Know About How to Trade Straddles

No. 1: You are not the only person looking at the market

I know. It’s shocking, right? No. Right now there are literally millions of people looking at every stock that trades. They read what you read. They use the same analysis you use. The “wisdom of crowds” theory states there’s a good chance they have pretty similar thoughts about that same stock as you do. And… Some of them beat you to the punch.

You can bet your last dollar some traders bought that straddle before you. And there are others who just bought the puts as a hedge or bought calls as a spec. The demand has already begun to drive the price of those options higher (this is the effect of implied volatility).

If you think of the “value” (value in the classic sense, meaning usefulness) of a straddle being that you can make money if you see the volatility you expect, you pay for that value. And just like anything else that has value, at some point, the price can be so high it’s no longer worth it.

Here’s how that plays out with this option strategy…

No. 2: There ain’t nothin’ in this world for free

With a straddle, you’re buying the benefit of being able to make money whether the stock goes up or down. But it’s not really the total cost you pay for the straddle that is the most important factor (you can sell it later, so the straddle price isn’t really the cost). The true cost is more like the “daily rent” for having this benefit: “theta.”

All options lose value as time passes. That’s called time decay and it’s measured by one of the metrics we use to make smart option trading decisions—the option Greeks. The option Greek that matters here is theta.

Every day the stock doesn’t move enough, you lose a little bit on this “daily rent.” And that’s a fair trade-off. After all, you’re betting on increased volatility. The bet is: You get volatility you make money; you don’t get volatility you lose money.

But when demand is high for the straddle, the total cost of the straddle is higher. That also means the theta is higher. It’s running against the wind a bit. But if you get enough volatility, you can still win.

That, however, is complicated by our final thing to know about trading straddles…

No. 3: The wind gets stronger

We have to get in the weeds a little bit here. But here we go…

As shown, when implied volatility rises, theta rises. But the other relevant option Greek here is a second order Greek called “gamma.” In a nutshell, gamma, in this case, is how much money you make on your straddle given a unit move in the stock.

When gamma is high, if the stock moves up or down, say 1%, you make more than you do when the gamma is low—sometimes a lot more. Many traders don’t look at this. But this actually determines whether you make money. It’s the most important factor of all.

But here’s the thing, when implied volatility rises, not only does theta get bigger, but gamma gets smaller. This is what I like to refer to as “the double whammy.” It’s sort of like running against the wind—with ankle weights on.

Beating the Game

Knowing these 3 key factors is a game changer when it comes to trading straddles. This will help you select better trades, avoid trading the bad ones and set better expectations to pick better profit taking targets.

If you want to make straddle trading work, the first thing to look at is that implied volatility number. If it’s too high, the straddle might be “priced out,” making the prospect of a winning trade too much of a challenge. But here’s a little trick…

Look back at where the stock traded in the recent past to get a feel for how far it might reasonably move. Then look at the price of the straddle at a strike price that distance away from your strike price. This is what I call “the gamma hack,” and it’s a great estimation for how much you would make given a reasonable expectation for volatility. Then you can easily decide if the trade is worth the risk.

For example, imagine you’re looking at the $230 straddle priced at 9.25. The recent trading range shows an $8 move is reasonable over the next couple of days. Here’s what you do…

Look at the prices of the $222 straddle and the $238 straddle (both $8 away from your strike). Those straddle prices are a great estimate for what the straddle will be worth if the stock indeed moves $8. If the profit is enough to balance the risk of the stock not moving enough, and therefore losing from theta, you can feel good about taking the trade.

But remember, as each day passes, theta works against the trade, so you’ll have to repeat this process every day. If a few days pass and the trade has yet to show a profit, it’s a good time to exit and move on to the next, better opportunity and another chance to bring in some profits.

Dan Passarelli
Founder and President
Market Taker Mentoring, Inc.

« Previous PostA Look at Market Reversals and Relationships Next Post »Using Double Distributions to Identify Trends

Please add your comments


Options Trading Blog

Archives

Tags