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How We Trade Straddle Option Strategy


For those not familiar with the long straddle option strategy, it is a neutral strategy in options trading that involves the simultaneously buying of a put and a call on the same underlying, strike and expiration. The trade has a limited risk (which is the debit paid for the trade) and unlimited profit potential. If you buy different strikes, the trade is called a strangle.

How straddles make or lose money

 

A long straddle option strategy is vega positive, gamma positive and theta negative trade. It works based on the premise that both call and put options have unlimited profit potential but limited loss. If nothing changes and the stock is stable, the straddle option will lose money every day due to the time decay, and the loss will accelerate as we get closer to expiration. For the straddle to make money, one of the two things (or both) has to happen:

 

1. The stock has to move (no matter which direction).
2. The IV (Implied Volatility) has to increase.

 

While one leg of the straddle losses up to its limit, the other leg continues to gain as long as the underlying stock rises, resulting in an overall profit. When the stock moves, one of the options will gain value faster than the other option will lose, so the overall trade will make money. If this happens, the trade can be close before expiration for a profit.

 

In many cases IV increase can also produce nice gains since both options will increase in value as a result from increased IV.
 

This is how the P/L chart looks like:
 
tp 1.PNG

 

 

When to use a straddle option strategy

 

Straddles are a good strategy to pursue if you believe that a stock's price will move significantly, but unsure as to which direction. Another case is if you believe that IV of the options will increase - for example, before a significant event like earnings. I explained the latter strategy in my Seeking Alpha article Exploiting Earnings Associated Rising Volatility. IV usually increases sharply a few days before earnings, and the increase should compensate for the negative theta. If the stock moves before earnings, the position can be sold for a profit or rolled to new strikes. This is one of my favorite strategies that we use in our SteadyOptions model portfolio.

 

Many traders like to buy straddles before earnings and hold them through earnings hoping for a big move. While it can work sometimes, personally I Dislike Holding Straddles Through Earnings. The reason is that over time the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.

165_straddlestrategies_421x236.jpg

 

Selection of strikes and expiration

 

I would like to start the trade as delta neutral as possible. That usually happens when the stock trades close to the strike. If the stock starts to move from the strike, I will usually roll the trade to stay delta neutral. Rolling simply helps us to stay delta neutral. In case you did not roll and the stock continues moving in the same direction, you can actually have higher gains. But if the stock reverses, you will be in better position if you rolled.

 

I usually select expiration at least two weeks from the earnings, to reduce the negative theta. The further the expiration, the more conservative the trade is. Going with closer expiration increases both the risk (negative theta) and the reward (positive gamma). If you expect the stock to move, going with closer expiration might be a better trade. Higher positive gamma means higher gains if the stock moves. But if it doesn't, you will need bigger IV spike to offset the negative theta. In a low IV environment, further expiration tends to produce better results.

 

Straddles can be a cheap black swan insurance

 

We like to trade pre-earnings straddles/strangles in our SteadyOptions portfolio for several reasons.

 

First, the risk/reward is very appealing. There are three possible scenarios:

 

Scenario 1: The IV increase is not enough to offset the negative theta and the stock doesn't move. In this case the trade will probably be a small loser. However, since the theta will be at least partially offset by the rising IV, the loss is likely to be in the 7-10% range. It is very unlikely to lose more than 10-15% on those trades if held 2-5 days.

 

Scenario 2: The IV increase offsets the negative theta and the stock doesn't move. In this case, depending on the size of the IV increase, the gains are likely to be in the 5-20% range. In some rare cases, the IV increase will be dramatic enough to produce 30-40% gains.

 

Scenario 3: The IV goes up followed by the stock movement. This is where the strategy really shines. It could bring few very significant winners. For example, when Google moved 7% in the first few day of July 2011, a strangle produced a 178% gain. In the same cycle, Apple's 3% move was enough to produce a 102% gain. In August 2011 when VIX jumped from 20 to 45 in a few days, I had the DIS strangle and few other trades doubled in a matter of two days.

The main risk to this strategy is earnings pre-announcements. They can cause volatility crash and significant losses.


To demonstrate the third scenario, take a look on SO trades in August 2011:

 


765ced7eea8ed2cc5dbbd556781c568c.png

 

To be clear, those returns can probably happen once in a few years when the markets really crash. But if you happen to hold few straddles or strangles during those periods, you will be very happy you did.

 

Summary

 

A long straddle option can be a good strategy under certain circumstances. However, be aware that if nothing happens in term of stock movement or IV change, the straddle will bleed money as you approach expiration. It should be used carefully, but when used correctly, it can be very profitable, without guessing the direction.

 

If you want to learn more about the straddle option strategy and other options strategies that we implement for our SteadyOptions portfolio, sign up for our free trial.

 

The following Webinar discusses different aspects of trading straddles.

 

 

Related Articles:

Buying Premium Prior to Earnings
Can We Profit From Volatility Expansion into Earnings
Long Straddle: A Guaranteed Win?
Why We Sell Our Straddles Before Earnings

 

Want to learn more? We discuss all our trades on our forum.

 

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Thank you Kim.

I have been using earnings straddles for years with great success. As you mentioned, stock selection is very important and not every stock will work for this strategy. It is critical not to overpay for the straddles, based on prices on previous cycles.

Edited by DavidR

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You are absolutely right. We do extensive backtesting to determine which stocks are suitable to trade earnings straddles. It will always be a race between theta and vega, and the race is not linear. We need to enter at the point where theta is winning, e.g. the price is low, before vega causes it to spike. In some cases like our recent ORCL trade, some members were able to milk the same stock 2-3 times.

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Kim,

I went over your track record, and as far as I can see, the average return of the straddles is around 4-5%. Is it even worth the effort?

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4 minutes ago, Guest Bobby said:

Kim,

I went over your track record, and as far as I can see, the average return of the straddles is around 4-5%. Is it even worth the effort?

That is correct. But returns have to be considered in context. 

First, you need to consider the holding period. We hold those trades on average 5-7 days. So making 5% in less than a week is not too bad.

Second, you need to look at the risk. We rarely lose more than 7-10% on those trades, so the risk is relatively low. And the winners can be significant, especially if the overall market volatility spikes.

And the most important thing - as I mentioned, it could be a cheap black swan protection. So you basically have portfolio protection AND get paid for it. I'm not familiar with another strategy that can hedge your portfolio not only for free, but actually produce gains. 

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We are now improving this strategy even further, based on an idea from one of our members. For some stocks, when prices are still reasonable, it makes sense to enter early (2-3 weeks before earnings) and sell a strangle against the straddle with shorter expiration and certain ratio. This enhances the gains by 3-5% on average and pushes the average returns closer to 10%. Combined with low risk and short holding period, I believe you will have a hard time to find a better strategy on a risk adjusted basis.

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28 minutes ago, Kim said:

We are now improving this strategy even further, based on an idea from one of our members. For some stocks, when prices are still reasonable, it makes sense to enter early (2-3 weeks before earnings) and sell a strangle against the straddle with shorter expiration and certain ratio. This enhances the gains by 3-5% on average and pushes the average returns closer to 10%. Combined with low risk and short holding period, I believe you will have a hard time to find a better strategy on a risk adjusted basis.

@Kim, just curious - you mention that complementing the straddle with a short strangle bumps the average return up, is there a trade-off for higher risk that goes along with that, or in the backtesting you did on this strategy, did you find that the average risk on this modified strategy is more-or-less comparable to the risk on corresponding straddles? Thanks!

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The main risk is reduced gains in case a stock makes a big move. Also, depending on the ratio, the black swan protection is much less than doing straddles only.

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Just now, Kim said:

The main risk is reduced gains in case a stock makes a big move. Also, depending on the ratio, the black swan protection is much less than doing straddles only.

I see, I didn't consider the black swan element - thanks. So on average, the max loss on these trades should be slightly smaller then?

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@Kim You mentioned that you backtest extensively: " We do extensive backtesting to determine which stocks are suitable to trade earnings straddles. It will always be a race between theta and vega, and the race is not linear. We need to enter at the point where theta is winning, e.g. the price is low, before vega causes it to spike. "

Can you point me to a video or thread which discusses your preferred method of back testing and all the variables for which you are looking?  I've read through the different threads about the various software, and I'm assuming your preferred method is still using ONE Explorer?

Thanks,

Steve

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