Straddles are terrific strategies to employ when wanting to have a built-in hedge. Depending on how the position was set-up, straddles can profit from quick explosive moves in both the up and down directions. The straddle can be implemented purely delta neutral, allowing them to profit the same, whether up or down. They can also be engineered to have a directional bias where the position would profit quicker to the downside if a bearish bias is possessed, and to the upside if a bullish bias is possessed. Regardless, there are certain criteria that should be adhered to when implementing a straddle position.
To review, the straddle strategy is constructed by purchasing an equal number of puts and calls with the same strike price and expiration month on the same underlying equity. A long straddle is typically employed in a volatile market where the options strategist believes the market will move but does not have a bias on the direction of movement of the market. This is the delta neutral version, and, basically, as long as there is significant movement upwards or downwards, this strategy offers profit opportunity.
By virtue of the fact that the straddle strategy requires a relatively big move to make the position profitable, there are certain selection parameters that must be applied to potential stock candidates. First, you want to locate stocks that have historically been explosive but are currently exhibiting low implied volatility, meaning their options are cheap.
Some of the best straddle opportunities occur around an earnings event, especially when you expect a move of 8 percent or more. Also, if they tend to gyrate wildly during earnings and are currently consolidating with low implied volatility, then these certainly would be stocks to put on the radar screen.
When the trader actually initiates a straddle, they need to allow around 90 days before expiration. Keep in mind that the primary objective of the straddle position is to look for an implied volatility increase as well as significant stock movement. In addition, the trader should never hold the straddle strategy any longer than 45 to 50 days, and if profits exceed the 35 to 40 percent level, the trader should look to take profits.
More aggressive traders can hold for the 50 percent level and stay in the strategy up to 60 days, provided it is practical to still do so. If consistently applied correctly on carefully selected stocks that meet the key criteria outlined in this article, then the straddle can be a strategy that can become a profit center within your trading business. Also, if managed properly the straddle has very little risk attached to the position, which is always an attractive characteristic of any effective options strategy.
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