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April 25, 2006

Traders Who Know Their Options Could Be Winning with a Straddle

By International Trading Institute

The profit and loss graph of this short straddle at expiration would look like this: Let's run through a few "What if" scenarios for the short straddle. 1. Stock rallies to 58 prior to expiration If the stock rallies to 58 at expiration, you would experience a loss. Your put would expire worthless. You would incur a loss of $8.00 on your short call (less the $5.00 you received for initial sale of the straddle), resulting in a net loss of $3.00. 2. The stock drops to 44 at expiration If the stock drops to 44 at expiration, you would again experience a loss. This time your call would expire worthless, and you would incur a loss of $6.00 on the short put. Thus, your net loss would be $1.00. Again the premium you received for the initial sale of the straddle would offset your loss by $5.00. 3. Stock sits right at 50 at expiration If the stock ends up right at the 50 strike at expiration, this would be our best-case scenario. Both options would expire worthless and we would keep the initial credit of $5.00. Now, having a solid understanding of a long and short straddle, we will focus on the management of the long straddle position. Rolling The Position This time let's look at DEF stock again and assume we bought the DEF 60 straddle for $6.45. We purchased the call for $2.45 and the put for $4.00. After studying the charts for DEF, you noticed that volatility is low in its range. The Implied Volatility Index for 52 weeks shows a high of 79.25 and a low of 35.84 and the current level is 36.40. We like this stock because it is in a wedge; it will most likely go above its down trend-line or consolidate to lower levels. Also, the stock has a history that when it drops, it drops hard and fast and when it rallies, it really jumps. Therefore, a $7.00 move is not unrealistic. Let's assume that when we initiated the straddle we were looking for a move in either direction, either above 66.45 or below 53.55, with about 8 weeks to go to expiration. Now, it's four weeks to go until expiration. Let's look at a couple of scenarios.