When there is volatility in the market or on a stock you are familiar with, long straddles can be a winning options strategy.
The concept behind this uses the basic rights of a call option and a put option on the same stock. As long as the market on the stock rises or falls enough to cover the cost (premiums), then the long straddle will be a profitable options strategy for you. There is also limited risk with long straddle positions. The most an investor can lose are the combined premiums spent.
To understand this strategy, it is best to describe the contracts themselves. A long straddle is made up of 2 types of options - Calls and Puts. A call option gives the holder (buyer) the right to buy the stock at the strike price. If the market rises, the call will be profitable or "in the money". When an options investor owns a call, he has an unlimited gain. If the stock declines, the contract could expire worthless. A put gives the holder the right to sell the security at the strike price. When the market on the stock goes down, the put will gain in value. If the market goes up, the put will expire worthless and the trader would lose his entire premium.
Long straddles take advantage of each type of option and uses them together. The aim then is to see if a stock can move enough or have wide trading fluctuations or a wide trading range which allows the straddle to flourish.
Stocks to use
The best candidates (stocks) for long straddle strategies are securities that you are familiar with. Perhaps you own a stock that over-reacts to bad news, good news, earnings announcements or has a wide trading range that it bounces off of. The thought process of a long straddle purchase is you are not gambling on the stock going only up or only down. You are anticipating movement, but you are unsure of that direction. If a trader thinks the stock is going up, then he should only buy call options. Long straddles cost more because of the premiums paid for 2 contracts. You can buy more than 2 of course, but you are buying options on each side of the market.
Long Straddle Example
Buy 1 WEL Jul 40 Call@4 ($400) Buy 1 WEL Jul 40 Put@3 ($300)
These option contracts cost the investor $700. The straddle is long, because the investor bought them both. Regardless of what happens with the stock itself, a premium cost of $700 must be made up. The trader needs WEL stock to rise 7 points (47) for the call to be profitable enough to exercise or trade or for the market to decline 7 points (33) for the put to be profitable. 33 and 47 are the 2 break even points on this long straddle. Any point above or below those 2 levels will make this investor $100 on the straddle (based on one contracts each).
The most the investor can lose is the $700 premium cost.
Long straddles carry large or unlimited profit gains, but as with all options strategies - gain potential is offset with the possible loss of the initial investment. Play the stocks you know and look at the trading range. Experience with the stock itself is key and can be your ticket to big money in long straddles.
More information on all straddles
Happy Trading!
Nick Hunter is the President of American Investment Training. Their website http://www.aitraining.com offers investors and brokers with education courses, investment information and a free financial glossary look-up.
