Option Straddle Strategies Explained

Options straddle strategies are very popular and profitable. They are very similar to strangles, another neutral strategy. There are two different types of straddles, a long straddle, and a short straddle – both for their own purposes. It is extremely easy to set up and trade this strategy.


Video Breakdown:


Short Straddle Option Strategy

short straddle
Short Straddle Payoff

Market Assumption:

A short straddle is a neutral/range-bound strategy. It is used when you assume that the price of an underlying will stay between two points until expiration. You can move these two points a little more to the upside/downside to create a slightly directional straddle. But in general, this strategy should still be traded with a range-bound market assumption. This is another quite popular strategy for neutral high probability trading because the break-even points can be quite far apart. Theoretically, you could target OTM strikes and create a very directional short straddle, but I really don’t recommend this.

Setup:

  • Sell 1 Put
  • Sell 1 Call (at same strike price)

To make a straddle as neutral as possible you should use ATM strikes.

This should result in a credit (You get paid to open).

Profit and Loss:

This is an undefined risk and defined profit strategy (just as seen on the payoff-diagram above). This means there is no set limit to how much money you could lose, but there is a limit to how much you can make. But because the Premium taken in is quite high, the profit potential is rather good and the break-even points are fairly far apart. Maximum Profit is achieved when the price of the underlying is exactly at the strike of the two short options. With this strategy, you first begin to lose money when the underlying price moves very far away from your targeted strike.

Maximum Profit: Premium received – Commissions

Maximum Loss: N/A (unlimited)

Implied Volatility and Time Decay:

A short straddle profits from a drop in implied volatility and should, therefore, be traded in high IV environments (IV rank over 50). Doing this will increase the premium taken in and the chances of winning.

Time Decay or Theta works in favor of this strategy. This means every day the two sold options lose a small part of their value which will increase your probability of success. The amount of time decay increases the closer you get to expiration.

 


Long Straddle Option Strategy

long straddle
Long Straddle Payoff

Market Assumption:

The long straddle is a very easy neutral/price indifferent options strategy. This means that you assume that the price of an underlying will make a big move in the near future, but you don’t know in which direction. The long straddle will profit from a big move in either direction. This can be used for bigger events/announcements where a big move isn’t unlikely.

Setup:

  • Buy 1 Put
  • Buy 1 Call (at the same strike)

Usually, an ATM strike is used

This should result in a credit (You get paid to open)

Profit and Loss:

Just as seen on the payoff-diagram a long straddle is an unlimited profit and limited risk strategy. The max loss normally still can be relatively high. But the maximum loss occurs very rarely, because to achieve max loss the price of the underlying has to be precisely at the strike price of the long options. That this happens is rather unlikely. But if the price doesn’t move far enough, you still will lose money. As soon as the price of the underlying security moves far enough, you begin to make money. The further it moves the more money you make.

Maximum Profit:  N/A (unlimited)

Maximum Loss: Premium Paid + Commissions

Implied Volatility and Time Decay:

A long straddle profits from a rise in implied volatility and thus should be used in a low IV environment (IV rank under 50). This will make this strategy cheaper to enter and will increase the chances of winning.

Theta or time decay does not work in favor of a long straddle. The long options bought in this strategy constantly lose some of their extrinsic value. The closer to expiration the higher losses through time decay become.

2 Replies to “Option Straddle Strategies Explained”

  1. Great to know about the Straddle strategies. Actually I am not from Trading background, but this strategical fundamentals clarify my knowledge. Also they increased my interest in trading.
    Thanks
    AMY

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