Stan Freifeld

Straddles: When You're Not Sure

    Tweet This

Free Trading Guides

Which Way To Move?

OK, so when do we reach into our bag of options strategies and pull out the straddle? It's when we expect the stock to make a large move, but we're not sure in which direction the movement will take place.

This can happen when an event is expected, such as earnings, a verdict in a court case, an FDA announcement, etc. There can also be unexpected events, such as a takeover, merger, announcement of a new product, or the replacement of a key officer of the company, etc., that will cause the stock to make a large move.

Let's examine the characteristics of this spread in terms of the greeks that we spent so much time learning about. I'll talk about the long straddle, but you know that the short side will be just the opposite.

DELTA and GAMMA: Assuming that the straddle was put on with the stock price close to the strike price, the delta will be close to 0, approximately +50 for the call and -50 for the put. That means that the position doesn't have a bias to either the upside or the downside. However, since the position is long the call and the put, and since both calls and puts have positive gamma, the straddle is very long gamma. This means that as the stock starts moving away from the strike, it will get shorter on the downside and longer on the upside. That's exactly what we want!

We want the stock to move as far as possible from the strike price. In fact, we can see from the graph that the worst place that the stock could be at expiration would be at $50. In that case the straddle would be worth 0, and we would lose the entire investment of $3,750. In reality, we would have either exited the position prior to expiration or made adjustments along the way, and most probably would not have lost the entire amount.

It's also always useful to know the breakeven points on the upside and downside. Fortunately, in the case of a straddle it's easy to calculate. Simply add the premium to the strike price to get the upside breakeven of $50 + $3.75 = $53.75, and subtract the premium from the strike price to get the downside breakeven of $50 – $3.75 = $ 46.25.

VEGA: Again, since the position is long options and long options have positive vega, this position is very sensitive to changes in volatility. So in addition to price movement, we are hoping for an increase in volatility. Well, that implies that we would put this position on in a low volatility environment. Isn't that a contradiction? We want low volatility, but large movement in the stock!

Yes and no: at expiration the volatility doesn't matter anymore. The stock price will be whatever it is, and that will determine the amount of profit or loss for the position. Prior to expiration, the volatility can have a great impact on the value of the straddle.

It is possible that with only a small movement in the stock, but with a significant increase in implied volatility, that the straddle could still be profitable prior to expiration. Sometimes we can have our cake and eat it too!