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How To Execute An Effective Straddle Strategy With Options

The long straddle is probably the most popular of all options hedges. This particular strategy is direction neutral and has limited risk; profit potential is theoretically unlimited. A straddle is created by purchasing a put option and a call option at the same strike price with the same expiration date. The trader's desire is that the underlying will unexpectedly become significantly volatile in the short term. The straddle combination profits if the underlying jumps in either direction, or if implied volatility increases, before option expiration. If the underlying just sits still, loss of most or all premium is possible. A long straddle is a speculation either that the underlying will move a lot or that implied volatility will go up significantly.

Maximum Gain

Gain is theoretically unlimited with a straddle. Ideally the underlying will make a huge move up or down. At expiration, profit would equal the difference between the underlying and the strike minus the option premiums and account fees. Upside profit potential is theoretically unlimited; downside profit potential is limited by how far the underlying can fall to zero.

Maximum Loss

At expiration, should the price of the underlying be at the exact strike, both of the straddle's purchased options would be worthless, all premium would be lost.

Breakeven

At expiration, the long straddle will break even if the underlying's distance above or below the strike is equal to the option premiums. In other words, one option expires worthless while the other has an intrinsic value equal to both premiums.

Effect of Volatility

The straddle combination would succeed merely by experiencing a sudden growth of implied volatility even if the underlying did not move. In this case, both options would have increased value. On the other hand, should implied volatility decrease, both options would lose value.

Effect of Time

Each passing day, the straddle's value erodes when the underlying moves insignificantly or not at all. All else being equal, the rate of erosion increases in the final weeks and days of the combination's life.

Risk of Automatic Exercise

One of the straddle's options may trigger automatic exercise should the trader choose to hold the position to expiration. This risk can be reduced by using time specific options that don't trade on the underlying security, like binary options. Binary options brokers can help you work out a adequate straddle if you are worried about the risk of automatic exercise.

Barring a jump in implied volatility, the underlying must move dramatically for the straddle trader to see a profit. The straddle can be very risky to hold to expiration. Always keep in mind, when a particular underlying is widely expected to move, the market will demand higher premiums for the relevant options; this reduces the possible payoff should the underlying jump in price.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.