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Straddle Strategies in Option Trading

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Straddle Strategies in Option Trading Powered By Docstoc
					by: Steven T. Ng

The straddle strategy is an option strategy that's based on buying both a call and put of a stock.
Note that there are various forms of straddles, but we will only be covering the basic straddle
strategy. To initiate a Straddle, we would buy a Call and Put of a stock with the same expiration
date and strike price. For example, we would initiate a Straddle for company ABC by buying a
June $20 Call as well as a June $20 Put.

Now why would we want to buy both a Call and a Put? Calls are for when you expect the stock
to go up, and Puts are for when you expect the stock to go down, right?

In an ideal world, we would like to be able to clearly predict the direction of a stock. However, in
the real world, it's quite difficult. On the other hand, it's relatively easier to predict whether a
stock is going to move (without knowing whether the move is up or down). One method of
predicting volatility is by using the Technical Indicator called Bollinger Bands.

For example, you know that ABC's annual report is coming out this week, but do not know
whether they will exceed expectations or not. You could assume that the stock price will be quite
volatile, but since you don't know the news in the annual report, you wouldn't have a clue which
direction the stock will move. In cases like this, a Straddle strategy would be good to adopt.

If the price of the stock shoots up, your Call will be way In-The-Money, and your Put will be
worthless. If the price plummets, your Put will be way In- The-Money, and your Call will be
worthless. This is safer than buying either just a Call or just a Put. If you just bought a one-sided
option, and the price goes the wrong way, you're looking at possibly losing your entire premium
investment. In the case of Straddles, you will be safe either way, though you are spending more
initially since you have to pay the premiums of both the Call and the Put.

Let's look at a numerical example:

For stock XYZ, let's imagine the share price is now sitting at $63. There is news that a legal suit
against XYZ will conclude tomorrow. No matter the result of the suit, you know that there will
be volatility. If they win, the price will jump. If they lose, the price will plummet.

So we decide to initiate a Straddle strategy on the XYZ stock. We decide to buy a $65 Call and a
$65 Put on XYZ, $65 being the closest strike price to the current stock price of $63. The
premium for the Call (which is $2 Out-Of-The-Money) is $0.75, and the premium for the Put
(which is $2 In- The-Money) is $3.00. So our total initial investment is the sum of both
premiums, which is $3.75.

Fast forward 2 days. XYZ won the legal battle! Investors are more confident of the stock and the
price jumps to $72. The $65 Call is now $7 In-The-Money and its premium is now $8.00. The
$65 Put is now Way-Out-Of- The-Money and its premium is now $0.25. If we close out both
positions and sell both options, we would cash in $8.00 $0.25 = $8.25. That's a profit of $4.50 on
our initial $3.75 investment!
Of course, we could have just bought a basic Call option and earned a greater profit. But we
didn't know which direction the stock price would go. If XYZ lost the legal battle, the price
could have dropped $10, making our Call worthless and causing us to lose our entire investment.
A Straddle strategy is more conservative and will profit whether the stock goes up or down.

If Straddles are so good, why doesn't everybody use them for every investment?

It fails when the stock price doesn't move. If the price of the stock hovers around the initial price,
both the Call and the Put will not be that much In-The-Money. Furthermore, the closer it is to the
expiration date, the cheaper premiums are. Option premiums have a Time Value associated with
them. So an option expiring this month will have a cheaper premium than an option with the
same strike price expiring next year.

So in the case where the stock price doesn't move, the premiums of both the Call and Put will
slowly decay, and we could end up losing a large percentage of our investment. The bottom line
is: for a Straddle strategy to be profitable, there has to be volatility, and a marked movement in
the stock price.

A more advanced investor can tweak Straddles to create many variations. They can buy different
amounts of Calls and Puts with different Strike Prices or Expiration Dates, modifying the
Straddles to suit their individual strategies and risk tolerance.

If you want to read more information on straddles and other option strategies, visit
http://www.option-trading- guide.com/options_guide.html

This article was posted on February 24, 2005

				
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