For the past few weeks, we’ve been telling readers about options strategies designed for traders who want to step up their game by going beyond simple strategies like selling puts or buying covered calls.
Today, let’s address what’s known as a “combination trade,” an options strategy where the trader takes a position in both call and put options in the same underlying stock. Specifically, we will look at a very popular trade called a long straddle.
In this particular type of trade, an investor will purchase both a call and put on the same stock, and both of these options will have identical strike prices and expiration dates.
It may initially sound counterintuitive to be on both the long and short side of the same stock. If you’re only trading regular common stocks, it doesn’t make sense to be both long and short simultaneously. But when it comes to options, however, it is sometimes beneficial to enter into this type of trade. Let’s dive in and learn more…
How A Long Straddle Works
Straddles are designed to allow investors to profit from a large move in a stock. The beautiful thing is that the stock’s actual direction does not matter. The only thing that matters is whether the stock makes a substantial move.
This is the key point to trading straddles. You don’t have to be certain which direction the stock will move. You just have to be certain it will move strongly one way or the other. Because of this, straddles make an excellent choice in choppy markets where the only certainty is high volatility.
Let’s take a look at an example of how a straddle trade works…
Let’s assume that XYZ is currently trading at $100 per share. Due to a significant event that will occur soon (an expected news event, earnings release, product release etc.), a trader might believe that the stock will move at least 10% in either direction. In this example, let’s assume that both the XYZ 100 put options and XYZ 100 call options are trading at $3 each.
To trade this, you could enter a straddle trade by purchasing the XYZ 100 put for $3 and the XYZ 100 call for $3 (for a total of $6 out of pocket).
As you can see in the payoff diagram above, this particular straddle will be profitable if the stock price moves more than $6 in either direction by the time the options expire.
If the price remains at exactly $100, the trader will suffer a maximum loss of $6. Once the price of XYZ’s underlying shares moves beyond $94 or $106, the investor will begin to realize a profit from the trade. If the price moves at least 10%, as the investor predicted, to either $90 or $110, then the profit will be $4 ($10 sale of option – $3 purchase of call – $3 purchase of put).
It’s important to keep a few things in mind when using this strategy. First, options tend to gain value faster than they lose value. So any move (bullish or bearish) will result in an increase in the straddle’s value.
But, whenever you buy options, you are vulnerable to time decay. And this is especially true when it comes to straddles. It’s important to remember that time value doesn’t decay consistently. It tends to accelerate in the last two months before expiration, so it’s a good idea to close out of your position six to eight weeks before expiration.
Action To Take
With some planning and a little practice, you can use the same techniques that professional traders use to earn above-average profits.
Broadly speaking, the two strategies we’ve discussed recently (spreads and straddles) are designed to limit an investor’s losses yet still allow you to realize significant gains. By using multiple option positions simultaneously, you can create powerful tools to help you earn greater returns and manage risk in your portfolio.
P.S. If you’re looking to step your game up and achieve results like you’ve never seen before, then turn to our colleague Jim Fink…
Jim has developed a highly-successful system using strategies like this to devastating effect. The result: 626 winners out of 647 closed trades.
If you want to make more winning trades and earn more than you ever thought possible, Jim is showing a select group of investors how his system works. Go here for more details…