Option strategies that limit your risk: Buy a Straddle

Technically, buying a straddle means buying a call and a put with the same strike price and the same expiration month. If you buy a call and a put with different strike prices, this is technically referred to as buying a strangle. For our purposes, we will use the phrase "buy a straddle" to describe both strategies. An example of the Buy A Straddle strategy would be as follows: On 8/28/96, Intel was trading at 81.25. A trader could have purchased the October 1996 85 Call option at 2.50 and the October 1996 80 Put option for 2.88, for a total of $538 dollars. If this position was held until expiration, the trader has unlimited profit potential if Intel closes below 74.62 or above 90.38. If the positions are held until expiration and Intel closes between these two price levels, the trader will experience a loss.

Example:

Buy 1 ABC May 60 Call @ 3
Buy 1 ABC May 60 Put @ 2

The trader will pay a combined premium of $500. As shown in the graph below, the trader will profit if the market price goes above $65 or below $55. The entire $500 will be lost if ABC is exactly $60 at expiration.



In it's best light, Buying A Straddle is an excellent strategy for a trader who feels that a given stock or futures market is about to make a large move but isn't sure about the direction of the move. By buying a call and a put simultaneously, he has unlimited profit potential should the underlying make a large move in either direction. In it's worst light, Buying a Straddle can be considered the worst of all worlds. You pay two option premiums plus two commissions, the underlying market absolutely has to make a fairly substantial move in one direction or the other in order for you to simply break-even, and you lose time premium every day, not just on one position but two. In general, anything less than a major market move will leave you with a loss when buying a straddle. The key when buying a straddle is to stack as many favorable variables in your deck as possible and to avoid the obvious pitfalls, which reduce your chances of making money.

The keys to making money when buying straddles are:

A. Selecting the right options to buy. If you buy options that are far out-of-the-money the probability of one of the options eventually trading in the money is extremely low. Thus time decay begins to eat away at the price of your options. If you buy options too close to the money, it increases the move that the underlying needs to make in order to generate enough profit on one option to offset the loss on the other option. Your best bet is usually to buy the best priced near-the-money options.

B. Buy only when implied volatilities are low. If you buy a straddle when volatility is high, you put yourself in a situation where the underlying stock or futures contract absolutely has to make a major price movement to have any hope of making money on the trade. For this reason you should only consider buying a straddle when the Relative Volatility for the market in question is less than 3.

C. Buying options with plenty of time left until expiration. While these options cost more to buy they give you a higher probability of making money by giving the market more time to make a move and also by delaying the negative effect of time decay. Ideally, you should buy options with at least 45 days left until expiration when entering a straddle. Once you have entered a trade following steps A, B and C and have decided how much you are willing to risk on the trade, you must then be patient and give the underlying stock or futures market time to move. If the underlying fails to move and the option prices fall and you get stopped out with a loss that is simply part of trading. However, if you decide to exit the trade simply because you are getting impatient waiting for the underlying to move, that is a mistake. As long as you have entered the position with adequate time left until expiration, do not be too quick to change your mind.

When To Exit Long Straddle

Exiting at a Loss
Determine before entering the trade if you will hold until expiration or cut your loss at some point. If you are planning to cut your loss, then determine the maximum downside risk on the trade (which is simply the amount you paid to purchase the options) and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then exit entire position.

Exiting at a Profit
Choice 1:

1. If you are trading only one call and one put, then:
   
2. If one of the options bought doubles in price, set 1/2 of your remaining open profit as a trailing stop. Raise trailing stop as profits keep rising.
   
3. If one of the options bought triples in price, close all positions.
   
4. If one of the options bought goes 3 strikes in the money, close all positions.
   

If you are trading more than one call and one put, then:

1. If one of the options bought doubles in price, sell half of your position and set 1/2 of your remaining open profit as a trailing stop. Raise trailing stop as profits keep rising.
   
2. If one of the options bought triples in price, close all positions.
   
3. If one of the options bought goes 3 strikes in the money, close all positions.
   

Most traders tend to overstay their welcome when buying straddles. The popular notion is that you have to "hit a few home runs" to make up for some of the 'strike outs". So when a trader gets a large profit on one side of a long straddle he will often hold on and hope for a huge winner to develop. More often than not this does not happen and a decent profit often turns back into a loss as the market reverses, time decay eats away at the option prices, etc. The trading rules detailed above for exiting a long straddle at a profit are designed to take profits when they are available and do not generally wait around for "the big score".