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The major problem many traders have is determining the direction in which a particular stock will move. Will it go up or down in price? If we knew that, entering a winning trade would be quite simple: You'd buy the stock if it was going up, and you would sell the stock short if it was going to drop. Alternatively, if you knew the stock would rise, you could buy a call (or sell a put); if you knew the stock would head down, you could buy a put (or sell a call).

However, what can we do if we have no idea of which way the stock will move? We could enter a "Delta Neutral" trade, one in which we'll profit regardless of which direction the stock takes. A Delta Neutral trade is one in which calls, puts and the underlying stock are combined in such a manner that the positive deltas and the negative deltas of each component sum to zero.

The straddle is probably the easiest of the Delta Neutral trades to create. It consists of being long one call and long one put, both with the same strike price and expiration date. The strike prices of the straddle must be purchased at-the-money, or ATM, to be Delta Neutral. If the strikes are at anything other than the stock price, then the trade will not be Delta Neutral; it will have either a negative or positive delta bias, depending on whether the strikes are above or below the stock price.

The idea of the straddle is that as the stock moves up in price, the long call becomes more valuable. Although the long put will lose value at the same time, it won't lose value as quickly as the call gains value. In addition, there is a lower limit as to just how much value the put can lose -- it can only go to zero. Thus, as the stock rises in price, the net effect is that the straddle gains in value.

Of course, if the stock falls in price, the opposite will happen. The long put will continue to gain value while the long call will lose value, but only until it reaches zero. Thus, if the stock loses value, the total straddle position will gain in value. The risk curve for this particular trade at expiration, then, would look like Figure 1. LBE is the lower break-even point, where the trade will generate a profit as the stock continues downward, and UBE is the upper break-even, where the trade will be profitable as the stock rises.

Risk Curve of a Straddle

Source: Optionetics

As you can see in Figure 1, the straddle will be profitable in both significant up and down moves. The only time a potential problem exists is when the stock stands still.

The major problem with a straddle is that it consists of two options: a put and a call. As we're purchasing both options at the money, the entire value of the two premiums is Time Value. As Time Value is not "real" in that it has no inherent value and it decreases to zero as the option approaches expiration, we have the crux of the problem: The stock must move, and move soon, to recover the money lost by the erosion of time in the trade.

There are two ways the trade will be profitable. First, obviously, the stock's significant move would increase the value of one option while simultaneously decreasing the value of the other option, albeit at a slower rate. Second, both options could increase in value. The only way that can happen is to have the volatility of the options increase. All other variables in the Black-Scholes Option Pricing Model will affect puts and calls in opposite directions.

If the volatility of the option increases, then the option premium will increase, and the possibility of the stock moving will also increase (the basic concept of what volatility is measuring). Thus, if you can find a stock with relatively low volatility, which is increasing, the value of the straddle will be increasing and the stock will be likely to move either up or down -- a double chance for profit.

To be successful in trading straddles, we need to find a stock whose volatility is low but is about to increase as the stock begins to move. This may sound like real guessing at first, but in reality, it is not too hard to discover. The primary, most reliable reason for an increase in volatility and for the stock price to move is news. News can be anything from court decisions to new product discoveries to accounting "irregularities" to earnings announcements.

Of the various news possibilities, earnings reports are the easiest to predict and the most common. Every quarter, each publicly traded company is required by the

Securities and Exchange Commission

to report earnings, meaning there are four chances for the stock to move unpredictably each year. Further, each announcement will tend to be made at about the same point in each quarter.

The natural state of things is for the stock's price movement, and hence volatility, to be relatively low until some announcement, or the anticipation of an announcement, triggers an uptick in the volatility. Between announcements, a firm's volatility will tend to be low and then rise as the earnings date approaches, dropping back down after the announcement and subsequent stock movement.

Thus, to enter a successful straddle trade, you only need to determine far enough in advance just when the earnings announcement will be made, enter the trade and then wait for the announcement date. In the normal case, on or about the announcement date, the volatility will spike up and the stock will make its move one way or the other. At that point, you exit the trade.

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Calculations

There are only three calculations necessary to determine the parameters of the straddle. First is the cost of the trade, the maximum loss possible. This is simply the sum of the premiums for both the calls and the puts.

If stock XYZ is trading at $71, the 70 strike call is trading at $3, and the 70 strike put can be purchased for $2.75, the total cost and the maximum possible loss on the trade will be $5.75 ($3 + $2.75 = $5.75) per share, or $575 per position (consisting of one call and one put). (The term "at the money" doesn't necessarily require the option strike price to be exactly the same price as the stock. As long as you are relatively close, the term will apply for entering a trade. Of course, at expiration, ATM means exactly that: The stock must be exactly at the strike price for the option to be ATM.)

The upper break-even would be simply the strike price ($70) plus the total per-share debit of the trade, $5.75, which equals $75.75 ($70 + $5.75 = $75.75).

Similarly, the lower break-even would be the strike price minus the per-share debit of the trade, or $64.25 ($70 - $5.75 = $64.25).

This gives you the outside parameters for the trade to be profitable -- this is if you went to sleep and waited for the options to expire. However, because the trade is really designed to take advantage of a quick uptick in price movement and volatility, you don't want to stay in the position until expiration. Instead, you will want to exit the trade as soon as the news breaks, as that is when the volatility will tick up, and it is when the stock should move. If you wait much beyond that time, the volatility will calm back down, and the stock may return to its previous price, taking all of your profits from the trade.

The only thing left in designing this trade is to decide just which options to purchase. If you're trading on an upcoming earnings announcement, you'll want to enter the trade far enough before the announcement that the average investor isn't thinking of it, the stock isn't in the news, and hence the volatility is low and the option prices will be low.

The optimal time seems to be about three to four weeks before the earnings announcement. Then, you want to have enough time in the option so that not too much Time Value is lost for the three to four weeks you're in the trade. After all, each position consists of being long two options.

Time Value erodes faster as expiration nears. Thus, to prevent as much Time Value as possible from eroding from this position, you'd use options that have significant time left until expiration. The problem here, of course, is that as you go out in time, the price of the option increases, increasing the debit of the trade. If you choose an option expiration date that is about four months out from when you enter the trade, then only about 15% of the Time Value should erode in the three to four weeks you'll be in the trade. This, of course, assumes that everything else, including volatility, remains constant.

Thus, in our example, the maximum risk that we'd experience is less than $1 if we made sure to exit our four-month Straddle at the earnings announcement date (about four weeks into the trade), regardless of what the stock did.

Here's a recap of the trade.

Entry Requirements

1. Look for relatively low implied volatility of the options. It must be low relative to the historic volatility of the options, and preferably below the volatility of the underlying stock.

2. Find an expected catalyst to tweak the volatility upward and to move the stock. Anticipation of an earnings announcement is a good catalyst.

3. If you're using an earnings announcement, enter the trade before most traders are paying attention -- three to four weeks before the anticipated announcement date.

4. Purchase equal numbers of ATM calls and ATM puts for each position. The expiration dates will be the same as well and should be a minimum of 90 days out, preferably 120 days to 150 days from the entry point, to minimize the time erosion from the trade. Put the trade in as a straddle, with your broker specifying the total debit you're willing to pay. This will ensure that you get the entire position for your price, even if the stock moves slightly and the relative prices of the calls and the puts have changed.

Exit Requirements

1. Exit the trade upon the issuance of the earnings announcement, regardless of your profit or loss at that time. By holding the position past the announcement date, you will then suffer the double Time Decay of the two options, with no reasonable expectation of anything to move the stock.

2. Exit the trade when you have a 50% profit if the stock jumps before the earnings announcement. This might happen if there's an unexpected announcement before the earnings release. You don't want to hang on to the position if it moves quickly, as it could easily settle back down, reducing or eliminating any profits you have in the trade.

3. To exit the position, sell both the put and the call simultaneously. The only exception to this rule is if one of the options is worth very little (say 20 cents or less) and you think the stock may reverse its move. If the winning side of the trade is enough to give you a profit without the losing option, keep the loser as a free lottery ticket -- you've paid for it in the straddle and its value may increase in the next several weeks or months if the stock retraces its price movement.

4. As with all long option positions, if you violate all the other rules, do

not

hold on to a long option with 30 or fewer days left until expiration -- sell what you have for whatever you can get. Looking at the risk graph, you can see that there's unlimited profit to both the upside and downside. However, the nature of this trade is such that it seldom returns triple-digit profits. You're not in the trade long enough to make those kinds of gains. However, it is a reasonable trade to generate steady profits, month after month.

Good trading.

By Andrew Neyens, staff writer and trading strategist at

Optionetics.com. Send him email at

aneyens@optionetics.com.