With earnings season right around the corner, options players might want to look into employing a long straddle strategy. A long straddle is typically used ahead of expected volatility (such as before earnings or a product launch), when the trader expects a big move but isn't sure of the direction. It can also be used in anticipation of a breakout on the charts after a long period of consolidation. Below, we'll look at the ins and outs of a long straddle: How it's played, the pros, the cons, and what traders should look out for.
How and When to Enter a Long Straddle
A long straddle is initiated when the trader buys to open a call option and a put option on an underlying security, using the same strike price and expiration, often making sure the strike price is "near the money."
We recommend initiating this strategy five to 10 days before the date of the anticipated move, before heightened volatility expectations inflate option premiums. It's also a good idea to purchase these contracts when they're still "on sale," if possible. This can be determined using the Schaeffer's Volatility Index (SVI), which measures near-term options prices against all other readings for the past year.
Straddling XYZ Before Earnings
To put this in perspective, lets say Company XYZ is set to unveil earnings two weeks from now. The trader thinks the stock could make a major move but isn't sure of the direction. If Stock XYZ is trading just below $70, he could buy to open one 70-strike call and one 70-strike put, using near-term options (or options that encompass the expected move, at least).
If the call is being asked at $0.61 and the put is being asked at $0.95, the trader's total cash outlay for the straddle would be $156 ([0.61 + 0.95] x 100 shares), or $1.56 per pair of contracts.
Long Straddle Risks and Rewards
As such, the trader will profit if XYZ shares make a big move in either direction. Specifically, the speculator's profit will increase the higher XYZ moves north of $71.56 (strike + net debit), and is theoretically unlimited to the upside. The investor could also profit on a move below $68.44 (strike minus net debit), with gains increasing the closer XYZ shares move to zero.
On the other hand, the stock could remain stagnant through the expected period of volatility. If XYZ remains right at $70, the maximum potential loss is $156, or the premium paid to initiate the straddle.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
