Straddles - Risks Determine When They Are Best Used

The straddle is a good example of how risks may be defined by the conditions of the underlying and its price movement in the all-important proximity status; and time remaining until expiration.

In the case of a long straddle (one long call and one long put with the same expiration and strike), you need significant price movement in order to exceed a breakeven price. There are two breakeven prices, one above the call's strike, and one for the put below the put's strike. These points are equal to the total debit paid for the straddle, combining both call and put, after adding trading fees. So the time remaining determines the potential for the position to become profitable; and the longer the time, the higher the cost.

For example, as of the close on June 28, the following positions could have been opened on Boeing (BA), which closed at $334.65:

            8-day expiration, July 6:

                        335 call, ask 5.15, plus trading fees = $520

                        335 put, ask 5.35, plus trading fees = $540

                                                Total cost $1,060

            22-day expiration, July 20:

                        335 call, ask 9.00, plus trading fees = $905

                        335 put, ask 8.85, plus trading fees = $890

                                                Total cost $1,795

The 8-day term to expiration requires movement either above or below the strike of 10.60 points. Breakeven prices are $345.60 (above) and $324.40 (below). That is a significant price range to accomplish in only 8 days. And given the fact that expiration week has only 4 trading days (due to the July 4 holiday), time decay will be exceptionally rapid that week. The odds are against this position becoming profitable in such a short term.

The 22-day expirations require 17.95 points of movement to reach breakeven. That means the stock must reach a price of $352.95 (above) or $317.05 (below) to reach breakeven.

This is the long straddle dilemma. Either expiration comes up too soon or price is too high, each making profits less likely.

A long straddle is a risky strategy of these combined problems. With this in mind, the only time a long straddle makes sense is when the underlying is a high-volatility stock, or when you expect it to become high-volatility, even in the short term. For example, if a company has a history of earnings surprises and a relatively narrow trading range, a long straddle may be set up to take advantage of price movement in either direction if earnings are better or worse than analysts' expectations. However, this is a speculative strategy even in these circumstances.

A short straddle may be considered very high-risk because one side or the other will end up in the money. This is speculative, of course. However, there is one condition in which the short straddle's risks may be mitigated. When the stock is in a period of consolidation, and attempted breakouts have failed over a period of many months, a short straddle is more likely to succeed, with the stock price remaining between resistance and support. So a straddle with strikes within those levels has a chance of ending up profitably, as long as consolidation holds. However, a trader would want to keep an eye on further attempted breakouts and be prepared to act if a breakout were to succeed. Actions may include closing the side that has moved in the money, rolling forward, or covering the exposed side (for example, if the call moves in the money, buying 100 shares or buying a later-expiring long call provides cover).

The advantage in a short straddle is that in selecting short expirations, time decay will be rapid. The Friday before expiration is a perfect time for opening a short straddle. Between Friday and Monday, the average option loses one-third of its remaining time value. And with the Wednesday holiday in the week before July 6 expiration, a short straddle remains speculative, but could be profitable just based on rapid time decay.

For example, Boeing reported the following ATM option values for the July 6 expiration cycle:

            8-day expiration, July 6:

                        335 call, bid 4.85, less trading fees = $480

                        335 put, bid 5.00, less trading fees = $495

                                                Total cost $975

The short straddle sets up a limited profit range equal to 9.75 points in either direction, between the underlying prices of $344.75 (above) and $325.25 (below). Again referring to exploiting time decay, the underlying can range anywhere between these breakeven prices, and both sides of the short straddle can be closed at a profit. This is due to time decay on both sides, as long as underlying movement is not too rapid. This is the wild card in the position, of course.

If the underlying price moves in the money on either side beyond the extent of the price buffer (9.75 points), one side ends up in the money. It has to be closed at a small profit (due to time decay) or a small loss; or rolled forward. If the price trend continues, it spells trouble for the short position still in the money.

With these risks in mind, it could make sense to close earlier rather than later to avoid the problem. With the 4-day week ahead, the timing is excellent; that does not mean the risk have disappeared.

The point is, "risk" is not limited to the attributes of the position (long or short). It also includes proximity to resistance and support, time to expiration, volatility of the underlying, and the price pattern in effect (a consolidation trend, for example).

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.