Straddle's a Good Fit for This Market

Whether you are a beginner or professional investor, predicting the direction of a stock is almost impossible. We know that there are three directions a stock can move: up, down or nowhere.

During these uncertain times of war, terrorism and geopolitical unrest, an investor can capture a profit from the volatility of a stock. Even though the CBOE Market Volatility Index (VIX) continues its downward trend, a straddle is a good strategy to implement if you believe that a stock's price will have a drastic move but are unsure of the direction of that move.

"The risks associated with buying a straddle seems to be lower than in years past, due the VIX being at a 10-year low and continuing its downtrend," says Walter Haslett, chief investment officer at Write Capital Management. "With all of the uncertainty today, a straddle can be a good way to play the cheap out-month volatility."

A straddle is the most popular volatility strategy and one of the easiest to understand. It it, the investor buys both the at-the-money call and at-the-money put with at least three months left to expiration. An option is considered at-the-money if the strike price of the option equals the market price of the underlying security. A strike is the price at which an asset can be bought (for a call) or sold (for a put) by the option holder upon exercising the option. The expiration date is when the options expire. (Check out TheStreet.com Options Alerts EduCenter for more on various options terminology, as well as more articles on options trading.)

The stock price must move significantly in order for the investor to make a profit. Keep in mind that stocks that are historically volatile in nature tend to have higher option premiums, or the amount paid for an option.

Here is the risk/reward of a straddle trade:

The maximum risk is your net debit, or price you paid for the calls and puts.

The maximum reward is unlimited.

The break-even to the downside is the strike price minus net debit.

The break-even to the upside is the strike price plus the net debit.

Playing Both Sides A straddle provides a winning strategy regardless of which direction a stock moves

Click here for larger image.

Source: Investopedia.com

The chart illustrates that by being long a straddle, an investor is unbiased about the stock's direction, meaning he or she doesn't care which direction the stock moves, as long as it has a substantial swing.

Let's look at a few real-world examples to see how this strategy would work, with Linear Technology, Merck and Intel.