With earnings season underway, we decided it would be beneficial to explore one way options traders can profit from a big stock move in either direction. Today, we will be looking into a strategy called the long straddle. A long straddle consists of buying a call option and a put option with the same strike and expiration date. This essentially takes direction out of the equation, so the position can profit whether the stock goes up or down, and risk is limited. However, the stock move must be big enough to cover both premiums that were bought.
We sat down with Schaeffer’s Senior Options Strategist Bryan Sapp to gain insight on the best ways to trade a long straddle. As one of the strategists behind our straddle-driven Volatility Trader series of options trading recommendation services, Sapp knows a thing or two about this two-option strategy.
Is a straddle truly a “directionless” trade?
Bryan Sapp: Straddles can be constructed to have some directional bias, but generally at Schaeffer’s, we prefer to trade them in a directionless manner. If there’s a discrepancy on strike selection — for instance, if the stock is trading at $34.50 and it offers option strikes of 34 and 35 — we will generally go with the prevailing trend. For example, if the stock has been rallying as of late, in this example, we’d choose the 34 strike for a slightly bullish bias.
When is the best time to buy straddles?
BS: The cut-and-dried answer to this question: immediately ahead of a volatility spike. However, this can be very difficult to predict. As a general rule, if we’re playing ahead of an event (earnings, Fed decision, etc.), we’ll try to enter our position slightly ahead of the actual event, in hopes that implied volatility (IV) will rally into that day.
For example, if we’re buying a straddle on a stock ahead of earnings, we’ve found that five to 10 days ahead of that date is the “sweet spot,” and oftentimes the increase in IV into the actual report will offset the time decay seen on the options. This can essentially give you a “free ride” into earnings, where the option prices will remain stable, or sometimes even appreciate into the event.
When should you avoid long straddles?
BS: We generally don’t like buying straddles on stocks or exchange-traded funds (ETFs) with “expensive” options on a relative basis. In order to determine what’s cheap or expensive, the Schaeffer’s Volatility Index (SVI) is a very useful tool. We have options data on stocks going back over a year, and the SVI will help us ordinarily rank the current options prices, and give us a relative idea of whether or not the current prices are cheap or expensive, based upon option pricing on that stock or ETF over the past year. This isn’t a perfect way to determine relative option value, but it can be very valuable when considered in the landscape of current volatility, potential events in the future, etc.
How do you find attractive straddle candidates?
BS: I generally start with charts, and look for stocks with Bollinger Bands that are compressed. Bollinger Bands are a way to look for volatility compression — i.e. – when the Bands are relatively narrow, that means the stock has undergone a period of low volatility, and vice-versa. By nature, volatility is mean-reverting, so a longer period of compressed volatility will generally lead to a period of volatility expansion.
As a straddle buyer, you’re attempting to enter immediately ahead of a period of volatility expansion. In addition to Bollinger Bands on a chart, I’m also looking for certain technical patterns that also coincide with volatility compression signals — some of my favorites include symmetrical triangles, ascending and descending triangles, and ascending and descending wedges. All can signal volatility to come.
Once I find technical setups that I like, I will then try to overlay options pricing with potential catalysts in the near future to try and predict when the actual volatility will occur. As a general rule, at Schaeffer’s we enter straddle trades with the “why now?” mentality. You generally want a potential reason as to why a stock is about to make a big move, outside of simply looking at technical indicators in a vacuum.
When would you recommend a long strangle over a straddle?
BS: If you have a fairly strong directional bias on a stock or ETF, then it makes sense to play it as a straddle. I generally like to buy straddles on stocks that I have no directional bias on, and have had the most success historically just playing a neutral strategy.
Do you typically play straddles right at the money, or do you occasionally pick up higher premium on one side of the trade?
BS: We tend to buy at-the-money (ATM) straddles, and have historically had the most success this way.
Have you ever been able to capitalize on a volatility surge that wasn’t accompanied by a big price swing?
BS: At Schaeffer’s, we generally target 100%+ gains on straddle plays. As a result, the volatility surge alone will very rarely allow for profit taking of that magnitude. That said, a near-term surge in volatility will get your trade off to a good start, and can oftentimes precede a big price move that will allow for necessary levels of profit taking.
Are there any benefits to trading straddles with weekly options vs. monthly?
BS: Absolutely. The advent of weekly options has been a game changer for straddle plays for us. In the trading world, more choices are generally a good thing. In this case, stocks with weekly options give us the ability to be more precise on the exact time frame for our particular view to play out. Additionally, more expiration choices allow us to buy the relatively “cheap” option series around whatever catalyst we may be looking for. The weekly options will all have different IV and prices, and we can hone in on the “best” options to get the most bang for our buck.
What advice would you give a first-time straddle trader?
BS: Patience and selectivity are key. Buying double premium (straddles, strangles, etc.) can be tricky, and I’ll say “no” to a trade far more often than I’ll say “yes.” Just make sure you have the right combination of technicals, cheap options, and a catalyst before entering a straddle.
Additionally, if you don’t think the straddle has the potential for at least a 100% gain, then don’t take the trade. Why risk 100% (theoretically, since you’re buying options) if you can’t make at least that amount, should things work out in your favor?
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