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Which is Better, Straddles or Directional Plays?

The market has been in a trading range since early August. The highs have generally been in the 1220 area and the lows in the 1120 area for the S&P 500 index. The only noteworthy exception was in the last week when we briefly touched 1100. The midpoint of that range is about 1160 and we closed yesterday at 1165. So there is reason to believe that this market may stay range bound for a while.

Straddles and their close cousins, strangles, are generally considered sideways strategies. Just to review, a straddle is selling a put and a call with the same strike at the same time. Whereas a strangle is selling an out of the money put and an out of the money call at the same time. Clearly the straddle will collect more premium but is probably riskier than selling a strangle because one of the options will almost certainly be in the money at expiration. For the most part this discussion will apply to both straddles and strangles because each is considered a sideways play.

Directional plays are those that benefit from a movement in one direction or the other. They can include trades that will be profitable if the stock goes sideways such as selling a put or a vertical spread.

First let us look at the pros and cons of selling a straddle or a strangle.

Pros

1. A straddle offers the most time value erosion of just about any strategy out there. Strangles are a close second. One reason for this is that you are selling both sides of the market and thus getting twice as much premium.

2. They are negatively correlated. One will profit from a move and one will lose because of the move. Overall risk can be lower.

3. In a time of high volatility where you expect the volatility to fall selling a straddle sells as much vega as possible and can be an ideal strategy.

4. The strategy makes the most money right in the neighborhood of the current stock price. The actual distribution of stock price changes is distinctly bell shaped and thus that is the most likely place for the price to be in the future. So this is a relatively high probability play.

Cons

1. A straddle will almost certainly be in the money on one of its legs. Overall profitability depends on how much premium was collected and how far the stock runs into the money.

2. Your probability of losing is roughly double that of a single sided option sale in a directional play.

3. In the event of a buyout, the call that was sold could get clobbered. I prefer to hedge that leg with a protective call bought at a higher strike. The secret to success in the market is living to fight another day.

4. In the event that you are wrong about volatility then you have twice as many options to lose on. That can be painful.

5. There is no chance to benefit from superior stock picking skills.

Let us discuss the pros and cons of directional plays.

Pros

1. Allow one to take advantage of superior stock picking ability.

2. Have about twice the probability of winning compared to straddles and strangles.

3. Can be closed early if the stock moves in the desired direction.

4. Have less exposure to vega risk.

Cons

1. Do not collect as much premium as a straddle or strangle can.

2. Do not make as much money if you have some ability to predict what volatility will do.

3. Some directional plays do not offer much in the way of negatively correlated returns.

Nothing in this article argues conclusively one way or another for one strategy over the other. Clearly there are tradeoffs and considerations to be made. An option trader needs both types of strategies in his tool kit to prosper in trading.

On Wednesday, October 19 at 6:00 p.m. EDT, TheStreet's Options Profits is hosting a webinar featuring Fred Ruffy of WhatsTrading.com. Join Fred as he outlines how to look at the "big picture", drill down into the sectors and ultimately find the individual options trade. Utilizing specific trade examples and case studies, Fred will show you how to select simple and advanced options plays. The back half of the webinar will include an interactive, exciting Q&A session.

Please email: jill.malandrino@thestreet.com to secure a slot for the webinar as space is limited and for the link to the presentation. If you have already RSVPd, there is NO NEED to send another response. A spot has been saved.

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