Stan Freifeld

Straddles: When You're Not Sure

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THETA: Again, we're still dealing with only long options, and long options have negative theta, so the position is losing value every day. Making matters worse, the rate of loss is constantly accelerating. So what can we do to mitigate this situation? We generally don't buy near-term straddles.

A rule of thumb is that straddle buys should be three months or more to expiration. I said "generally" for a reason. There are some situations where it does make sense to buy near-term straddles, and in fact, one of my favorite types of trades has to do with buying straddles on the day of, or day before, expiration. You'll have to keep reading these articles to learn about that one!

Why have I focused only on the long straddle? Take another look at the graph. Notice how it can have unlimited losses on both the upside and the downside. It's unfortunate, because there are times when you might want to sell the straddle but are afraid to assume the risk of a large price movement. Well, fear not, there are ways to control the risk, but that leads to another type of position (it's called a butterfly) on another day.

While you're digesting the above, I'm going to give you a bonus. It's something that most traders, including professionals, don't know. In fact, it's something I normally only share with my mentoring students. It's a formula, and here it is:

ATM Straddle premium = .8 x S x V x SQRT(T)

Where ...

S = Stock or strike price (they are the same since it's At-The-Money)

V = Volatility, and

T = Time to expiration in years

In the example above, S = $50, V =.023, and T = 60 days or .1644 years. Plugging into the formula yields: 0.8 x 50 x 0.23 x SQRT (0.1644) = $3.73 versus the actual premium of $3.75. Not too bad!

Stan Freifeld is an instructor with the Online Trading Academy. To learn more about him, read his bio here

This article originally appeared on The Options Insider Web site.