Having a strategy in the stock market is key to the success of any trader. Therefore, it is imperative that as traders, we keep expanding our toolkit. Today we will look at Option Strangles or Straddles.
These are popular strategies to use when you expect a big price move, but don’t know the direction like earnings or FDA approvals. If we can predict that the move is going to be big, it doesn’t matter which way, there is a strategy we can use to position ourselves for profit. Strangles or Straddles is when one buys both calls and puts; you lose money on one contract while you gain on the other as the price moves. The idea is that pretty much they cancel each other out until a certain point where the wins of one side overtake the loses of the other.
A straddle it’s when you choose the same strike price for the call and the put, while the strangle is when you choose different strike prices. Normally I want to choose a strike price where the calls and the puts premium costs about the same, so I am positioned in the middle of the move unbiased whether the price shoots up or down. For more expensive stocks I’ll go further out of the money just to get them cheaper, otherwise I will usually get them near the money.
One thing to keep in mind for this strategy is that Implied Volatility (IV) gets built into the premium as the catalyst event gets closer. Also, I like to keep in mind that Time is expensive, so it raises the premium for longer term plays. Generally speaking, you want to balance if you pay more for time premium then pay less for IV, and the other way around. For example, I wouldn’t want to buy a couple of days before with an expiration weeks after.
If I believe the move will be gradual, then I will typically use out of the money and longer timeframe, but not always. If I think there is going to be a big jolt around a particular catalyst, I will typically buy near the money with shorter time frames.
Some negatives about this strategy is that if the price doesn’t move enough, you can lose value on both your call and put simultaneously in two main ways. The first is as Implied Volatility (IV) decreases after the event it will affect the premium of both contracts negatively. The second is the value lost to time decay for holding the option. For context, losing up to 50% on your initial investment is a possibility, but since I normally would not hold the contracts to expiration, losing 100% of the investment is highly unlikely.
So here we go, strangles and straddles are an excellent way to play through catalyst because it allows ourselves to position for profit no matter the direction in which the price reacts as long as the move is big enough. And also, the downside risk is limited while the upside is unlimited.
Thoughts of a Psycho Trader…