The appealing thing about option straddles is that they’re non-directional. This means that you can make money without forecasting market direction. In other words, it doesn’t matter whether the stock price goes up or down in the near future – you can still make money either way – as long as it moves somewhere.
The idea behind a straddle is that you simultaneously purchase the same number of call and put options, with the same expiration date. The plan is, that thanks to option implied volatility and “the delta”, the profit from the winning option will more than compensate for the loss on the losing one, with a good profit remaining.
What to Look for With Option Straddles
Option straddles are a “slow-moving” trade that can take anywhere from a few days up to a month to do its thing. It works best on stocks that are in a period of price consolidation with the expectation that a breakout may be coming soon.
If you are a technical trader, one of the best chart patterns I have found for straddle trade setups, are what is commonly known as “triangle” or “wedge” formations. With the triangle pattern, this is where the recent highs and lows of the daily bar charts are coming together. In other words, the highs are getting lower while the lows are getting higher so that if you draw a trendline over the highs and lows, you’ll see them converging into a point.
You want to trade option straddles as near as possible to the convergence of the two trendlines. Even at the breakout moment is good. The best straddle breakouts come after you see this pattern forming for about 3 months. Anything shorter than that may result in a breakout that doesn’t have sufficient momentum to give you the maximum profit.
Another vital thing when buying option straddles is that you need to ensure that the options you buy have at least 90 days to expiration. If you do this during a period of price consolidation, such as in the triangle pattern above, the option prices are likely to be the cheapest around that time, due to low price volatility. This is ideal for straddle trades.
The downside of option straddles is that they cost more to enter than other trading strategies such as spreads. Nevertheless, in the US markets where option contracts only cover 100 shares, they are still quite affordable. If cost is a barrier to you, you might like to consider an alternative strategy called Victory Spreads. A double Victory Spread – done with both calls and puts, achieves exactly the same result as the options straddle but only risking a pittance by comparison.
You also want to avoid stocks that are historically slow-moving, because the whole idea behind a straddle is to anticipate a short-term price breakout that moves far enough before the option expiration date, to give you a net profit.
Another indicator that a price breakout could be imminent, is an upcoming earnings report, say, in about 3 weeks. Alternatively, a large movement in the overall market can also affect individual stocks.
Coming back to “triangle” patterns, there are three main types. Where the highs and lows are converging, this is called a “symmetrical triangle”. However, you often see the lows getting higher, but the highs being equal because they are hitting a resistance level. This is called an “ascending triangle”. The reverse of this is the third type, namely, descending triangles. These are ideal conditions to implement a straddle strategy.
The final thing you want to check before placing your order for option straddles, is the “implied volatility” in the option prices, compared to the “historical volatility” of the stock price. Ideally, the former should be lower than the latter. Any decent options broker will be able to provide this information.
Finding Triangle Patterns – The Easy and the Hard Way
Wading through a long list of stock charts to try and find triangle patterns can be a very tedious process. But if you have the software or a broker service that allows stock scanning, you can make the process much quicker.
Here’s what you can do.
There is an indicator known as the ADX, or “Average Directional Index”. It is usually used in conjunction with the +DMI and -DMI indicators, but for our purpose, we can ignore these. The general rule is, that when the ADX crosses above 15 the market is likely to break out. Below 15 the market is consolidating.
So if you have a scanning facility, you would set your stock price filter to between $20 and $10k and your ADX filter to crossing above 15. It will produce a list of stocks that qualify for both parameters.
Option Straddles Summary
Straddles are one of the safest and most stable option trading strategies available because you’ve eliminated the need to predict market direction. It does have some risk, namely, that the stock goes nowhere, in which case, time decay on your bought positions will work against you. But if you’ve purchased when the volatility is low and the price is cheap, your losses will be minimal. Straddle profits are theoretically unlimited, but anywhere between 20 – 50 percent per trade is quite easily attainable.
Straddle Payoff Diagram
There is an alternative that works exactly like the straddle but with this difference – the amount you lose if the stock goes nowhere is much less. They’re also more flexible, cheaper to put on and carry less risk.
They are called Victory Spreads
Enjoy This Video Presentation on Straddle Options Strategies
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