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How to do a Straddle Trade

 
     
 

On this page I give you the nuts and bolts for carrying out a Straddle Trade. Good Trading!

 

 
     
 
 
     
 

     
 
 
     
 
 
     
 

The Long Straddle, also known as "buy straddle" or simply "straddle" is a neutral strategy in options trading is when you purchase the same number of call and put options at the same strike price with the same expiration date.



 

What you need to know: Technical Analysis

Implied Volatility and Historical Volatility - the ideal candidate for a straddle trade is a stock whose current Implied Volatility is LOWER THAN its historical volatility. This means that it is trading relatively cheaper than it has over the last couple of months (depending on which period you choose for measurement). Your trading software will have this data (I use Thinkorswim, and their charting software gives excellent imformation), or you can download the Volcone Analyzer Software for more detailed information.

Price Consolidation - look for patterns of price consolidation. If you are familiar with technical chart patterns, look for a pennant or triangle pattern. Simply put, the highs and lows of individual price bars get closer and closer over a few days.

Stock price - you generally want to use stocks above $15, so that you have enough downside for the stock to drop in the case of a severe downward movement.

Timing - The timing of a straddle trade is important. You need to look at three factors: when to enter, time to expiration, and when to exit.

  • Entry - the best time to enter is about two weeks before an impending major news event, such as the company's earnings report (or the CPI, GDP or Fed). You should have already had a look at the stock's action after previous earnings reports to ensure that you have picked a stock that has shown a history of wild swings after a significant report. You can find this data (for Free!) on Yahoo! Finance or at Earningswhispers.com.
  • Time to Expiration - usually, time decay has its biggest influence in the last month before expiration, and therefore you will want to exit your trade at least one month before expiration. If you buy too far out before expiration, you will be paying unnecessarily high prices because of time value. You therefore want to buy your straddle with between two and three months before expiration.
  • Exit - Look to exit soon after your anticipated news event. If there has been little movement after the event, sell reasonably quickly so that you don't lose out to time decay. Or, if the expected price jump happens, sell the profitable leg at your predetermined profit target, but keep the other leg for now. For example, if the stock jumps up in price, the call wil become profitable and the put will be almost valueless. As long as your call profit is higher than your total original debit (cost of both the call and put together), you can take your profit. However, sometimes the stock swings back down again as others take their profits, or as the market corrects its over-reaction - at this point your put may also end up profitable!! In any case, ALWAYS sell both legs of the straddle a minimum of one month before expiration.

Calculations

Upper Break Even = Call strike price + Net Debit + broker commission
Lower Break Even = Put strike price - Net Debit - broker commission

Net Debit = Premium of Bought Call + Premium of Bought Put.

For example:

Stock XYZ at 22.35 per share on March 31. Implied Volatility is 18%, and Historical Volatiliy is 29%.

  • Buy the May 22 Call for $1.01
  • Buy the May 22 Put for $0.74

Max Loss = Net Debit = $1.01 + $0.74 = $1.75
Upper Break even = Call Strike + Net Debit = $22 + $1.75 = $23.75
Lower Break Even = Put Strike - Net Debit = $22 - $1.75 = $20.25
(Don't forget to include your broker commissions for both buying and selling the straddle!)

Other Tips
If your prefer and more conservative approach to buying two options: Long Strangle
If you are looking for a neutral strategy in which you can short (sell) options: Short Straddle

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