Options Education – Long Straddle
I received a great email from a subscriber that I wanted to share with everyone. The question essentially was “with the potential for volatility on the U.S./China Trade talks should we buy a straddle?”
This is an interesting idea, especially since the Dow futures traded lower by 300 points yesterday evening on a trade rumor, have fought all the way back to up 160 points today on, you guessed it, another trade rumor, and are now falling again on a trade rumor.
Because of this volatility buying a straddle is definitely a play that could work. But first here is an options education article explaining the risks and rewards of this strategy:
Long Straddle
A straddle is a good options strategy to pursue if a trader believes that a stock’s price will move significantly, but is unsure of which direction.
To purchase a straddle, a trader buys a long position in both a call and put with the same strike price and expiration date.
For example:
Stock XYZ is trading at 40
If you were to buy a straddle on stock XYZ, you would simultaneously do the following:
Buy the XYZ June 40 Call
Buy the XYZ June 40 Put
For a total debit of $4
If the stock were to close at 40 on the June expiration, you will lose $4 as both the call and put would expire worthless.
If the stock were to close at 36 or 44, you will break even.
If the stock were to go below 36 or above 44, you will make one dollar for every dollar the stock moves outside of 36 or 44.
Here is a graph depicting the Profit and Loss of a Long Straddle:
Now that we know what buying a straddle means, I want to talk about why this might not be the best strategy for this situation.
In general, the reason is that the market does a great job of pricing options. For example, a slow moving utility stock’s calls and puts are very inexpensive as the stock is unlikely to move dramatically. Conversely, a high flying growth stock’s options will be much more expensive as the stock is more likely to be volatile.
Similarly, ahead of earnings, or trade talks this week, the options market raises the price of options so that traders can’t buy cheap insurance for a big move.
Only very rarely are options prices extremely mispriced ahead of an event. And for that reason, buying a straddle, in an attempt to play a big market move today/tomorrow, is far from a sure thing.
That being said, if I did want to buy a straddle, I would likely target the general market via a buy of the S&P 500 ETF (SPY) October 293 Call and October 293 Put (both expiring 10/11) for $3.55.
Here is the risk/reward in this trade:
If the SPY closes at 293 tomorrow both the call and put would expire worthless, or a loss of $355 per straddle purchased.
My breakeven would be at 289.45 to the downside and 296.55 to the upside.
Below 289.45, and above 296.55, the straddle would make $100 per dollar the SPY were below or above those levels.
Another way to play this event would be to buy straddles on stocks sensitive to the trade deal.
For example, with Alibaba (BABA) trading at 165, I might buy the October 165 straddle (expiring 10/11) for $4.
Or you could consider buying straddles on the Semiconductor stocks, or really any sector or stocks sensitive to trade.