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Options Strategies Straddles

  
 

A word on Market-makers’ point of view on straddles: Market-makers and professional traders use the straddle information as an indicator to how much up or down the market expects the specific underlying asset will move in the very near future.

Let us say a company (symbol XYZ) plans to report its earnings in few days.
Now we will check the straddle price.The premiums paid for buying the call and the put contracts is X dollars.

With the time nearing the reporting day they see the straddle price usually inflated, because the market expects the underlying to move up or down more than the straddle price. Certainly, market-makers will prefer to sell straddles as high as possible and hope to be on the safe side and the straddle price will stay in the limits of the expected movement.

Example
Let us say XYZ is trading in the market for a price of $72.30. The straddle price is $4.20. This means that the market expects the stock to move more than 4.2 / 72.3 = 5.8% up or down.

Sometimes the market correctly predicts movements and sometimes not. Market-makers do not take too many chances and try to sell higher priced with historically lower probability to exceed these numbers. This also called selling at a premium to the highest bidder and selling volatility as high as possible.

The crowd on the other side buys calls and or puts according to their analysis. They pay a bundle of a premium and there is a chance that the entire profit from the movement will offset by the decline in IV or premium. Statistically most of the premium sold to the market stays with market makers; it is okay because they take the chance to be wrong from time to time and pay a lot of money back to the market.

Long Straddle Strategy

Long straddle strategy description: Buy ATM put and call strikes. This strategy's outlook for the financial instrument is going to be very volatile in the short-term. According to its typical characteristics, it will greatly lose value through time decay.

At expiration, if eventually both contracts' strike price will be equal to the financial asset price, the setup will end up worthless and total premium paid will be equal to zero.

Typically, this setup's category are best before a critical earnings report, FDA approvals or disapprovals, or major macro index that will have a dramatic influence on the movement of the underlying asset.

Prospect direction: The stock will be short-termed volatile either bearish or bullish, considering the duration disadvantage and implied volatility advantage or disadvantage, as you already know that, when a financial instrument declines normally its IV values will increase and for this strategy, it is good news and bad news if the opposite happens.

Profit potential: Theoretically unlimited, since the underlying instrument can move at least infinitely upwards and to zero downwards.

Loss potential: Limited to a premium paid for both contracts.

Risk / reward: Premium paid, divided by the unlimited profit.

Breakeven point at expiration: If the underlying asset is higher than the options strike price, then underlying price - premium paid - options strike price = zero. Or, if the underlying asset is lower than the options strike price, underlying price + premium - strike price = zero.

Time factor: For this setup, timing is very crucial. Both options are long, and certainly the time decay is double. For every day with no abrupt movement in the underlying asset, the losses from time decay will reduce the chances to win this trade.

Implied volatility: Typically, an increase in implied volatility would positively affect this strategy, all other variables being equal. Volatility tends to boost the value of any option, because it indicates a greater statistical probability that the stock will move enough to give the option intrinsic value by the expiration day. On the other hand, a decline in volatility has a tendency to lower an option's value, regardless of the overall stock price trend. One more thing about IVentering to a trade choosing high IV underlying asset will increase the time decay risk and a need for a sharper move either way, although the market in already pricing in this volatility.

Dividends: Dividend positively affects a long put option contract. On an ex-dividend date, the amount of the dividend will deduct from the value of the underlying stock. The second setup's component is the long call, which will lose from the dividend deduction.

The straddle strategy is unique; some market-makers are using this strategy in times when implied volatility is low, and they expect volatility to rise; some are using it for its typical characteristics just before a critical announcement; and some are using this strategy as directional. You can execute a straddle with options only, or combined with the underlying asset, in this article we will elaborate on few of its implementations in various ways.

  
 

 
 

Typical Straddle Setup
1. Buy ATM put and call options just before any critical announcement when there is a good chance for an abrupt move. Although it is possible that IV will rise a week or so before this critical announcement and you should consider entering at that point, a rise in the IV will boost the options price and this will compensate the loss from time decay. This will give you another chance to be there if the underlying will move before the note. Sometimes IV tends to rise so high before the news enough to give you an obscene profit so that you can get out of the trade right there.

2. Buy ATM put and buy equal delta amount in underlying. This setup is suitable for ‘Delta Hedging’ keeping the position in delta neutral. It is also called as ‘Volatility Buying’. Both actions gain from the underlying asset movement and from the rise in the implied volatility.

Directional Straddles
1. Buy OTM put and ITM call options - bullish.
This strategy is bullish-biased, positioning with ‘positive deltas’ letting the upside to be favored, also with less time decay erosion. The call option offsets most of the incurred loss, if it goes counter the preferred direction.

2. Buy ITM put and OTM call options - bearish.
This strategy is bearish-biased, positioning with ‘negative deltas’ letting the downside to be favored, also with less time decay value. The put option offsets most of the incurred loss, if it goes counter the preferred direction.