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Academy > Technical Analysis > What Is Options Straddle: Maximizing Trading Profits >

What Is Options Straddle: Maximizing Trading Profits

2022-08-26 05:18:02

Summary:

  • Straddle options are market-neutral trades that allow traders to hedge their trade and minimize their risk while maximizing their upside in the options market; the two most popular options for a straddle trade are “long straddles” and “short straddles”.
  • In a long straddle, a trader buys an option call and an option put with a strike price higher and lower than the spot price, expecting higher volatility. In a short straddle, a trader does the same but with a strike price close to the spot price, expecting lower volatility.
  • A long straddle is the most popular way to trade straddle options because the profit potential is higher and the markets are more volatile than they are stable over an extended time period. A short straddle is suitable for assets that had a stable price over multiple years.

Long straddle and short straddle

Derivatives provide the highest risk-to-reward ratio in trading. A trader can buy calls or puts on an asset and make a significantly higher profit than trading on the spot market.

What happens if we want to bet on volatility using derivatives? Traders anticipate news and place trades based on the volatility expected. If an asset is volatile, it provides higher returns once the price shifts in our direction – especially on options trades.

If we want to bet that an asset is going to be volatile, the hardest part is guessing the direction. Since we stand to lose our initial investment, we must find ways to hedge our position.

Straddling is an advanced trading technique that allows traders to hedge their trades based on volatility. A long straddle involves two trades in which traders bet that there will be significant volatility. A short straddle involves two trades in which traders bet that the price will remain relatively stable.

Both of these methods are effective for trading derivatives in the stock and crypto markets. In this guide, we’ll analyze long straddles and short straddles and how to successfully trade an options straddle.

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What Is A Long Straddle?

A long straddle is an options straddle strategy in which we bet the asset will have high volatility, and open two trades simultaneously – long and short. Traders do this by purchasing option calls and puts for an asset with a strike price removed significantly from the current spot price.

A straddle trader opts for long straddles to maximize their profit potential because investing in option calls can be far more profitable than investing in the spot markets for assets like stocks and crypto. If the strike price is met, the trader can make multiple times their initial investment.

In this diagram, we can see that an asset with a spot price of $250 would be in profit if it reaches either $280 or $220 using a long straddle trading strategy:

options straddle 1
Long straddles expect the price to leave the red middle area. (Image Source: Project Finance)

 

The downside of long straddles is minuscule because the trader is only risking their initial premium. As we’re hedging both ways by buying calls and puts, the asset price could go in either direction and we would still end up profitable. A straddle trade is executed by buying calls and puts at-the-money (ATM).

An effective long straddle trading strategy should be based on news that an asset is about to move – volatility is key. If the asset price doesn’t move by more than 5-10%, we won’t be making a significant profit, or we could end up at a loss once the options expire.

For this kind of volatility, there would have to be something occurring that could trigger a spike in volume and increase volatility. In the stock markets, earning reports create the biggest spikes in volatility because traders immediately price in the value of a company based on their quarterly earnings reports.

Pro Tip: Google the dates for earning reports of the company you’re trading. View historic charts to see how the earning reports affected the price.

In a crypto straddle trade, a trader should look for news about a project such as a partnership or a new side-project announcement could set off a volatile rally.

The point is that we’re not really concerned if the crypto is going to go up or down but that it will be volatile. If Bitcoin (BTC) or another crypto stays at the same price range, we won’t be able to make a profit using a long straddle trade.

Long Straddle Example

Let’s take a blue chip stock such as Amazon (AMZN) for our example. Amazon stock released an earnings report in March 2022, stating they made historic profits. The stock immediately appreciated from $135 to $170. Traders who long straddled the stock would stand to make a lot more than the 30% increase on that day on their ATM long calls.

In crypto, it is more difficult to gauge when there are going to be large movements in the market since companies don’t publish quarterly earnings reports. A crypto trader has to be tuned in with developments by reading crypto news sources and social media.

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Risks of a Long Straddle

The main risk with our long straddle trade example is that Amazon stock could’ve stayed the same, had the earnings reports been equal to last quarter’s. An earnings report release does not guarantee the stock will move, and many stocks remain stable during eventful times. If there is a lack of volatility and price action, our hedging technique fails and we lose our premium.

What Is A Short Straddle?

A short straddle is a hedged technique similar to a long straddle, but this time, we’re betting on low volatility. The trader purchases both a call and a put option on the asset, but they also have a strike price close to the current spot price. The only way the trader is in profit is if the asset doesn’t move much, and they make a profit by collecting the premium on both options when they sell at the end.

options straddle 2
Short straddles expect the price to stay in the middle green area (Image Source: Project Finance)

The downside of short straddles is a loss of premium, similar to long straddles. Short straddles are used a lot less by traders compared to long straddles because they limit the profit multiplier, and they are still riskier than trading in the spot market due to leverage.

Is A Short Straddle Bullish?

A short straddle can be considered bullish because the trader assumes the asset price will remain stable. If we aren’t expecting the asset to increase significantly, or decrease in any way, this is a viable trading strategy.

Short straddles are often employed by the most advanced traders who have a deep understanding of market patterns and know which stocks won’t be affected by news cycles from earning reports and similar events. If they analyze that a stock performs consistently without volatility, an option premium on a short straddle gives a higher profit than holding the stock.

Short Straddle Example

Let’s say we have a blue chip company that was in business for 100+ years and the price barely moves (due to consistent earnings). Coca-Cola stock is relatively stable with slow growth and has barely moved +2% over the last 6 months. Volatility on this stock is almost non-existent compared to tech stocks or crypto.

If we write a short straddle Coca-Cola (currently trading at $60) with a strike price of $65, and the stock stays in the $60-65 range, we would have two options near the expiration date to sell. We would only be at a loss if the stock moves above the $70s range or falls below the $50s.

Risks of a Short Straddle

The inherent risk of a short straddle is that we’re trading options with leverage and the upside is not as great as with long straddles where we can make a sizable profit on one large price move. Even if we stick to stocks that historically have low volatility, a general market downturn could wipe out our position and force us to sell for a loss.

A short straddle should only be implemented by advanced traders who understand market dynamics and have analyzed the historic performance of assets over many years.

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Long Straddle vs Short Straddle: Which Is Better?

The quick answer: Long straddles.

In a long straddle, the potential profit is unlimited – especially on volatile assets such as tech stocks and crypto. A medium percentage move on the spot market can leave a trader with a 10x multiplier on their initiation premium. The risk is also minimized since they’re hedging with calls and puts in both directions. The only risk factor would be a lack of volatility.

With short straddles, the trader is purchasing options with a strike price close to the current spot price and betting there won’t be volatility. A short straddle is risky in the current market which is highly volatile with indexes such as NASDAQ dropping as much as 30% in 6 months. If the asset goes up or down, they could face a total loss since they will not be covered in either direction.

Can You Straddle Crypto?

Crypto can be straddled and similar trading techniques can be implemented for Bitcoin, Ethereum (ETH), Solana (SOL), and all other coins. The main difference is that crypto exchanges won’t offer calls and puts the way brokers do in the stock markets.

However, traders can trade with leverage on the spot market or purchase perpetual contracts in the derivatives market (visit Phemex contracts). These contacts can provide similar returns to calls in the stock market, and they are priced according to the underlying spot price.

A trader could long straddle crypto by opening two trades: One leveraged long, and one leveraged short. By purchasing contracts on the perpetual markets, they can wait for the spot price to start moving in one direction, and then sell the losing contracts while taking profit on the winning contracts.

To learn more about contract trading, read What is Contract Trading ?

Conclusion

Long straddles and short straddles are some of the most-popular hedging techniques in the derivatives market that significantly increase a trader’s profit potential. Instead of all-out gambling by purchasing derivatives on one side, the technique adds a hedge to the trader’s position by betting on both sides.

The long straddle trading strategy is more commonly used compared to the short straddle strategy because of the upside potential. The volatility on a long straddle can lead to record profits, while the lack of volatility on short straddles can lead to smaller profits – requiring more attention to detail.

Each trader can develop their own straddle strategy. The same straddling techniques can be copied over to the crypto market and used for trading derivatives.


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