A straddle can be considered a volatility spread, as the trader who puts on the straddle is speculating on the volatility, or degree of movement of the underlying, not necessarily the direction of movement.
As with any option, you can choose to be either long or short a straddle. If you are long the straddle, you are expecting a substantial move in the underlying in one direction or the other. If you are short the straddle, you expect little to no movement. We will look at both a long and short straddle. However in this lesson, we will focus on when to employ a long straddle and how to manage it.
Although the primary reason you implemented a long straddle may have been due to the anticipation of a considerable price movement in an underlying stock, a sudden increase in implied volatility (and not the price of the stock), could also prove to be profitable for you in the case of a straddle.
When putting on a long straddle, you should allow adequate time prior to expiration to allow for the underlying market to move considerably. Straddles with only a few days to go until expiration can be quite profitable; however, they carry considerably more risk, since you have a greater requirement for being correct in your market assessment and less time to react.
The examples given do not include commission charges, which may be significant. In addition, multiple leg strategies, such as straddles and strangles, will incur multiple commission charges. Also note that a margin account will be required to carry these types of positions.
The long straddle combines the purchase of a call option and a put option both having the same underlying, strike price, and expiration.
Consider the following at-the-money straddle on the fictitious stock, DEF.
Composition:
Buy 1 DEF Oct 80 call @ $2.50
Buy 1 DEF Oct 80 put @ $1.50
Maximum Loss:
$4.00 (Amount paid to initiate the straddle)
Maximum Profit:
Unlimited to the upside for the long call
Unlimited to zero on the downside for the long put
Breakeven Points:
Strike minus premium paid on the downside: 76 (80-4)
Strike plus premium paid on the upside: 84 (80+4)
Greek Considerations:
Delta: Both options being at-the-money, their deltas will both
be approximately 50, thus off-setting each other (more on delta
later).
Gamma: Both the put and the call have positive gamma. The
value of the straddle will increase with any stock movement away
from the strike price.
Theta: Both the put and the call are will be affected by time
decay.
Vega: Both the call and the put are long vega. If volatility
increases, their premiums will increase accordingly. If volatility
decreases, their premiums will decrease accordingly.
We purchased the straddle for $4.00 ($1.50 for the put + $2.50 for the call). Therefore the two breakeven points would be $84 and $76. Because your cash outlay for the position was a total of $4.00, you know that this is your maximum risk.
The profit and loss graph of this spread at expiration would look like this:
Let's run through a few "What if" scenarios if you choose to hold the straddle until expiration.
1. Stock only rallies to 83 prior to expiration
If the stock only moved to 83 by expiration, you would experience a loss. You would make $3.00 on exercise of the long call, however, the put would expire worthless. Since you paid $4.00 for the straddle initially, this would net you a $1.00 loss.
2. Stock rallies to 88 prior to expiration
If the stock rallies to 88, you make a profit. You would make $8.00 by exercising the long call, and the put would expire worthless. This would net you a $4.00 profit since you paid $4.00 for the spread initially.
3. Stock drops to 68 prior to expiration
If the stock falls to 68, you again make a profit. The put is in-the-money by $12 and the call expires worthless. Since you paid $4.00 for the spread, you would net an $8.00 profit.
The Short Straddle
Let's take a look at a short straddle. Trading a straddle from the short side requires a totally different mind-set. Taking the reverse side of the trade will obviously bring the opposite risk/reward profile to your position. This will require greater monitoring of the short position, since the risk will be greater. The short straddle combines the sale of a call option and a put option, both having the same underlying, strike price, and expiration.
Consider the following short DEF at-the-money straddle.
Composition:
Sell 1 DEF Oct 50 call @ $4.00
Sell 1 DEF Oct 50 put @ $1.00
Maximum Loss: Unlimited to the upside. Unlimited to zero on the downside, minus the credit received for the straddle.
Maximum Profit: Credit received from the sale of the straddle. Breakeven Points: Strike minus credit received on the downside: 45 (50-5) Strike plus credit received on the upside: 55(50+5) Greek Considerations: Delta: Both options being at-the-money, their deltas will both be approximately 50, thus offsetting each other, just as with the long straddle
Gamma: Both the put and the call have negative gamma. The value of the straddle will decrease with any stock movement away from the strike price. Theta: It has a positive affect on the put and call. Vega: Both the call and the put are short vega. If volatility increases, their premiums will increase accordingly. However unlike the long straddle, the increase in premium works against your short volatility position.
We sold the straddle for $5.00 ($1.00 for the put + $4.00 for the call). Therefore, the two breakeven points would be $45 and $55.
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.
*The price of DEF has basically remained stable, and therefore the implied volatility has decreased. Moreover, time decay (theta) has begun to take its toll. You decide to reassess the situation and you still believe that the 60 straddle is worthwhile. You have a couple of choices. You can leave it alone, as you do still have four weeks left to see the movement you need. Or, you could roll the position to a month further out, thus giving DEF more time to experience the move you predict. To do this you would simply sell out the call and the put in the current month and reinitiate the straddle in a more distant month. *Now let's say that instead of DEF remaining stable, it had dropped three dollars. You could consider rolling down just the put. You would lock in a profit on the sale of the original 60 put, and select the new put by evaluating the current degree of bearishness, as well as the volatility of the puts you are considering buying. By purchasing a put with a new lower strike, for example the 50 put, this would create an entirely new position. You would no longer have on a straddle, you are now long the 50/60 strangle. Managing The Data Let's consider another alternative you have for managing a long straddle position. In this segment, we will show you how to help generate income through the dynamic rebalancing of deltas at key intervals using stock. With a straddle, profitability may not depend on movement of the underlying at all. If constructed in a theoretically sound manner, a straddle will have deltas that approach zero as they near expiration. If you are not familiar with delta, you can think of it as the "chance or probability of the option expiring in-the-money. Calls have positive deltas and puts have negative deltas. Therefore, the idea behind a classic straddle is to keep your position "delta neutral". An understanding of delta is essential if you wish to establish a stock equivalent hedge. Delta is technically the measure of the sensitivity of an option's value with respect to changes in the price of the underlying. The delta of stock can be considered 1 (or 100%). This makes sense because if the stock moves up $1.00 higher from the price it was purchased, you make $1.00 or 100% percent of the movement. If you are long then you have long delta. A positive delta expresses the direction you wish the underlying to move. Conversely, if you are short stock, you have negative delta. As in-the-money options expand to 100, out-of-the-money options decrease to 0. Options can have either negative or positive deltas; however, the deltas cannot be greater than 1 (or 100%) of the movement of the underlying. Remember that option premiums are derived from the price of the underlying. Because a long call gives you the right to purchase stock, thus having a positive market exposure, they have positive deltas. Call option deltas range from 0 to 100. At-the-money options have roughly a 50 delta. In-the-money options will have a delta greater than 50 and out-of-the money options will have a delta of less than 50. As an example, if a 100 DEF call has a delta of 50, then for every $1.00 move in DEF, the premium of the 100 call will change by $0.50 or 50 percent of the movement of the stock. If the DEF 100 calls had a premium of $10.00, with the stock trading at 100, the premium would increase from $10.00 to $10.50 with a move in DEF from 100 to 101. Since a put is bearish, it will have negative deltas. Put deltas will range from 0 to negative 100. As the underlying moves down in value, put options increase in value and therefore have negative delta exposure. A DEF 25 put with a delta of 70 will move $0.70 with a one-point move in the underlying. If the stock moves from 22 to 21, the option premium will increase by $0.70. If DEF moves from 22 to 23, the option premium would decrease by $0.70. Option deltas can be affected by other factors such as time and volatility. In-the-money options expand toward 100 the closer expiration nears. As the in-the-money options expand to 100 the out-of-the money options' deltas decrease to 0. Options with longer maturities and the same strike will have deltas closer to 50. For example, a call with a strike of 90 and 20 days until expiration has a delta of 99. A call with the same strike of 90 and 200 days until expiration has a delta of 78, which is closer to 50. Since we know that stock always has a delta of 100, to determine your underlying stock equivalent, you simply divide the stock's delta (100) by the option's delta. For example, if your option has a delta of 25, your result would be a 4:1 ratio. This means that you would need to sell one underlying for every four options contracts that you purchased. For example:
Sell 1 underlying having 100 positive deltas = -100 deltas Buy 4 options having positive 25 deltas = + 100 deltas Puts would be exactly the opposite. Because puts have negative deltas, you would purchase one underlying as opposed to selling it. You can also hedge options with options. For example, if you purchase 10 out-of-the-money calls, each call having a delta of +40, your delta position is +400. You could hedge your delta risk by purchasing 8 at-the-money puts, each having deltas of 50, or 400 deltas total, thus netting you a delta position of 0. The point being made here is that regardless of the number of calls, puts or underlying, the position can remain delta neutral, if the positive and negative deltas offset each other. In summary, a straddle accumulates long deltas as the underlying increases in value, and accumulates short deltas as the underlying decreases in value. Let's put this to practice. This time lets say you purchased the DEF 50 straddle with the stock trading at $50 and 52 days until expiration. You paid $3.10 for the 50 call and $2.50 for the 50 put, therefore you purchased the straddle for $5.60. The volatility is 30. It's two weeks later. Let's assume the following: *The stock is trading at 45 *Volatility remains at 30 *The put is trading at $6.25 and the call is trading at $1.00 *The put has a delta of 70 and the call has a delta of +30, therefore you have a net delta position = 40. You could purchase 40 shares of DEF (giving you +40 deltas), making your position delta neutral. This would mean that at expiration the straddle would be worth at least $200. If the stock is at $50 on expiration, the call and the put would both expire worthless, however you would make $5.00 on every share of stock, or $200 (40 x $5.00). Your net loss on the position would be limited to $360 ($560 – $200). This would be your worse case scenario. What if the stock closed at 54 at expiration? The put would expire worthless, the call would be worth $400, and the stock would make $360. Your position would now be worth $760, resulting in a net profit of $200. Consider if the stock dropped to 42 at expiration. The call would expire worthless, the stock would lose $120 (40 x $3.00), and the put would be worth $800. Our total profit would then be the value of the in the money put at expiration less the initial cost of the straddle less the loss on the stock purchased at $45, $70 ($800 $560 $120). You would continue to keep rebalancing your deltas by purchasing the underlying as the delta decreases, and selling the underlying as the delta increases, generating profits regardless of whether the straddle expires worthless, either reducing your overall cost of the straddle or adding profits. The management of deltas can also be done by selling calls as the underlying moves up and selling puts as the underlying moves down. The process of rebalancing the deltas of a straddle is called Gamma Scalping and will be covered in a future lesson in greater detail. The overall idea that we hope to convey about the straddle is that it offers many opportunities to be profitable, if all risks are fully understood and properly managed. Options are sophisticated investment vehicles and are not suitable for all investors. If you are considering trading or investing using straddles or strangles, we advise you to consult with a tax advisor as to how taxes will affect the outcome of the contemplated option transaction. To receive a copy of the Options Disclosure Document, please contact Karen Johnson at International Trading Institute, Ltd, 311 South Wacker Drive, Suite 3800, Chicago, Illinois 60606 (312 986 2000).
