What is a Straddle?A straddle consists of a put and a call with the same strike price. The straddle buyer anticipates a big move in the underlying stock before the straddle expires. If the stock goes up, the call increases in value, if the stock drops, the put increases in value. An attractive feature of a straddle is that the profitable option has unlimited gains, while the losing option has a limited loss. Straddles are often purchased in advance of an anticipated event, such as earnings, litigation settlement, or drug trial results.
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What makes a good straddle?Buying straddles can be very costly, and the underlying stock has to move enough to compensate for the cost of two option contracts. Straddles should be purchased when the likelihood of the stock moving outweighs the cost of the straddle. This condition can be identified by measuring the past price history and comparing it to the current option prices. If the option prices are historically low, then there would be an advantage to buying a straddle.
If a straddle is expensive, sell itIf the option prices are high, then the advantage is to sell the straddle. High straddle prices almost always signal a significant impending price change in the underlying stock.
A short straddle trader sells both the put and the call at the same strike price, collecting the premium from two options at once. These premiums can be quite substantial, and can sometimes represent more than half the overall value of the stock. The expectation is that the stock price will not change more than the amount collected from the sale of the short straddle.
A significant characteristic of the short straddle is that the time premium will drop after the anticipated event occurs, which adds to the potential profitability of the straddle. If the options on a stock are bid up in price in anticipation of earnings, the time premium on the options will drop after the earnings are announced, regardless of how the stock moves.
Covered call writers may think of this as selling both a covered call and a covered put. The position is not covered, however, since the long stock on the covered call cancels out the short stock on the covered put.
Straddle sellers look for high premium, since the amount collected from the sale of the straddle is the maximum profit. High premium straddles are identified daily at Optionistics.
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