The great thing about options compared to stocks is the plethora of ways in which investors can turn in a profit in the options universe. Compare this to stocks where an investor can only make money by going long or short, and it's easy to see why options have surged in popularity as investors have clamored for more ways to boost returns.
Many options strategies that may be foreign to novice investors have unique names such as butterfly, collar, condor, strangle and straddle. Let's take a look at the straddle and its usefulness in your portfolio.
The straddle is a relatively easy trade for even the most green investor to understand. It is a “neutral” options strategy, meaning that its profitability is independent of the directional movement of the underlying security. To execute a straddle, we simply buy or sell a put and a call at the same strike price. For example, if we want to initiate a long Company XYZ straddle, we might buy the June $16 put and $16 call.
One advantage of straddles is that they allow the trader to establish either a bullish or bearish posture while taking advantage of a volatile market. A trader with a bullish outlook would purchase a long straddle, buying a put and call with the same strike price and expiration date, just as we did in the example above.
On the other hand, the bearish trader would sell the June $16 put and $16 call, collecting a premium in the process.
Taking Advantage of Volatility
We mentioned earlier the usefulness of straddles during periods of increased market volatility, but how do we monitor volatility? Probably the best way of doing so is to watch the Chicago Board Options Exchange Volatility Index, commonly known as the “index833.” The VIX measures 30-day implied volatility for an array of S&P 500 index options, so its breadth encompasses the broader market. It is also regarded as a measure of investor fear. Regardless, straddle traders need to monitor the VIX.
The long straddle trader wants some volatility, which is to say he wants to see Microsoft make some wild daily upward price swings in a condensed period of time. He needs an increase in implied volatility. Since time decay works against the long straddle investor, if expiration date rolls around and those shares are hovering around the $16 strike price, the investor will have lost money.
Conversely, increased implied volatility is not the short straddle trader's friend. In fact, the astute investor would never select a volatile stock to initiate a short straddle with and would probably shy away from the straddle strategy altogether in a wild market. When we're short a straddle, we want to see the price of the underlying security languish at or around its strike price. We want choppy, sideways market conditions, not gut-wrenching price swings. If the price of the underlying security has move dramatically, up or down, prior to expiration we could lose money on the position.
Profit Potential of Straddles
Obviously, an investor wants to profit regardless of the trade and the straddle investor is no different. Since straddles have more moving parts than a basic stock investment, it's crucial that our risk/reward scenario is identified prior to putting on the trade.
In the long straddle scenario, the investor's cost is limited to the price of the put and the call contract. Say we only buy one put and one call at $1 each. That's $100 for the put and $100 for the call for a total of $200. ($1 x 100 shares = $100 for one contract). Our cost basis is $200 and that is the most we can lose, but since a stock has no ceiling for how high it can rise, our profit potential is unlimited.
Of course, in investing we have to take the good with the bad, and the potentially negative outcome with short straddles is quite risky. While we would take in $200 in premiums from selling the put and call, our loss potential is unlimited because the underlying security can keep rising. That's a fair amount of risk to incur just to earn some quick income in the form of premiums.
Not For the Faint of Heart
It's hard to ignore the allure of the straddle. Go long, and you have unlimited profit potential. Go short with the right boring stock or index, and your ability to identify securities that don't move is rewarded. That said, the straddle probably isn't the trade for an options novice to get his baptism. They can be expensive to initiate in the first place, and the potential to lose a large sum of money looms over each straddle trade.
Straddles are a useful trade to be sure, but it's probably best to cut your teeth elsewhere in the options world before getting your nerve up for a more advanced trade like this.