Friday, May 24

What Is a Straddle In Options Trading?

A highly volatile market

Options trading continues to become more popular. Research shows that options trading activity grew by 35 percent from 2020 to 2021. It also peaked in 2021, with 39 million contracts being traded daily.

If you’re new to options trading, you’ll want to know the right strategies and approaches to use to maximize your profits. The global COVID-19 pandemic saw numerous day traders and swing traders flock to trading options. However, research shows that most retail investors incurred significant losses instead of generating sizable returns.

Highly volatile trading chart patterns

What is a Straddle?

A straddle is a common options trading strategy that involves purchasing or selling call and put options for an asset at the same strike price and expiration date. A straddle strategy only works when the asset’s price falls or rises from the strike price and exceeds the premium paid.

Straddle strategies are most effective for highly volatile investments, as without price fluctuations, the premiums on multiple options outweigh potential profits.

Traders like to use straddles because they provide valuable insights into how the options market perceives a specific asset.

The Pros of Using a Straddle Strategy

  • Straddle strategies give you the potential to earn income regardless of whether the asset’s price rises or falls.
  • Straddle strategies are particularly effective when an announcement is expected, but people are unsure how it’ll affect the market.
  • Traders use straddle strategies to mitigate losses by hedging their investments.

The Cons of Using a Straddle Strategy

  • Straddle strategies only work for highly volatile assets. If the asset doesn’t experience substantial price swings, you likely won’t profit.
  • Traders purchase options and pay premiums for contracts even though they don’t plan to execute the contract.
  • Straddle strategies are highly reliant on market volatility. They don’t suit all market conditions.

Types of Straddles

Multiple types of straddles exist. These include:

The Long Straddle

The long straddle strategy involves purchasing a put and a call option at the same strike price and expiration date. It focuses on taking advantage of price fluctuations by capitalizing on increased volatility. It doesn’t matter which direction the market moves because the long straddle means you’ll be in an excellent position to take advantage of the price movement.

While the long straddle can be a useful strategy for options trading, it also has some drawbacks. For instance, traders face the risk of losing their trading capital, especially since long straddle strategies lack volatility. In addition, they’re also expensive.

The general rule of thumb for buying options contracts dictates that in-the-money and at-the-money options are significantly more expensive than out-of-the-money contracts. As a result, long straddles are risky because the cost of catching the market’s move might not be worth the risk.

The Short Straddle

The short straddle strategy requires the trader to sell a call and put option at the same strike price and expiration date. Doing so allows the trader to obtain a premium as a profit. However, it’s important to note that you can only profit from a short straddle when the market conditions display little to no volatility. Your ability to profit is based on the market’s inability to fluctuate up or down.

As a result, the short’s straddle strength is also its shortcoming. Selling a call and put option simultaneously allows you to generate significant income from the premiums. You can use this income to fund your trading account. Unfortunately, selling an option also means putting yourself at extremely high risk.

The ideal scenario for profiting from a short straddle revolves around the time and intrinsic value of the call and put options eroding. However, if the market fluctuates and moves in a specific direction, you’ll have to pay back the collected premium while also paying for accrued losses.

You can avoid incurring significant losses by purchasing the sold options.

A trader observing the market’s fluctuations on their phone

When Should You Use a Straddle Strategy?

You’ll ideally want to use a straddle strategy when you can observe one of the following criteria:

  • You notice the market is in a sideways pattern
  • Pending news, announcements, or earning reports will affect the market
  • Analysts have extensively predicted how a specific announcement will affect the market

It’s important to remember that analysts can significantly impact how the market responds to an announcement before it’s made. Analysts try to predict how an announcement will affect the market. For instance, let’s assume Microsoft plans to release its quarterly earnings report in a week. Experts will try to predict if their earnings report will match investors’ expectations. They’ll do their due diligence to see if Microsoft’s earnings will positively or negatively impact the stock price and give their verdict accordingly. Analysts generally present their estimates days or weeks before an official announcement is made, causing the market to move up or down. It doesn’t matter if the prediction is correct or incorrect. What matters for traders is how the market responds to these predictions because it affects their straddle and their profitability.

Once the official announcement is made, the market will react again. It’ll correspond to the predictions made by the analyst, moving further in the same direction, or the market will recognize that analysts were incorrect and decrease the momentum.

A properly created straddle proves useful because it can take advantage of such a market situation. Unfortunately, knowing when to use a short or long straddle is the biggest issue for most traders, meaning they can’t capitalize on such instances.

An options trader

Get Started with Trading Alphas

Getting started in options trading can be challenging for new traders. Fortunately, that’s where Trading Alphas can help. The company operates one of the best options trading Discord servers. In addition, Trading Alphas has a diverse community of over 1000 traders who have made over $25 million in profits.

Consider checking out their website for more information. You can also contact them to learn more about other trading options or sign up as a member today.