Trading Volatile Markets with the Straddle Options Strategy


Trading Volatile Markets with the Straddle Options Strategy

Volatile markets is when investors tend to lose sleep, as they toss and turn in bed feeling helpless while their portfolio gyrates up and down like a theme park roller coaster.  This year has been a prime example.  Investors hate a double sided market.

On the flip-side, volatile markets are the dream of the trader. We don’t care where the market goes, as long as it goes somewhere.

I will share one of my favorite volatility based trading strategies using the straddle options strategy.  It is very easy to implement, cost effective, and the profits can easily be triple baggers (300% +).

Market Conditions for Success – Trading Volatile Markets with the Straddle Options Strategy

First of all, it is important to recognize that this strategy is very profitable when you are expecting a significant move to happen in the market over the next few days to weeks.  We need actual volatile markets to implement the straddle options strategy.

You do not want to use this strategy if a massive move has already happened, or a massive news event has already been priced in.  Options are already very expensive at these times, stay away form long premium trades in these situations.

My personal tip: I love to use the straddle options strategy when we are at or near all time highs or big resistances, because you know there will be some large positions being entered into or exited, which can cause an imbalance that leads to a big move.

The Strategy – Trading Volatile Markets with the Straddle Options

Implementing the straddle options strategy is relatively simple.  It involves purchasing two options.

1. Long one call option with strike nearest to current market price
2. Long one put option with same strike as the call above

Setup and Implementation – Trading Volatile Markets with the Straddle Options Strategy

First, I should mention that I love this strategy on index options and index ETF options.  SPY, QQQ, IWM, GLD and DIA are my favorite.

The ETF that tracks the S&P500 is “SPY” – currently trading at $213.94 as of the Friday October 23rd close.

We believe the next 30 days will bring significant volatility in the markets through the presidential election period.  I don’t know where price will go but I don’t need to with the straddle options strategy, I just need volatile markets.

Step 1) Pull up the Nov 25th option chain for SPY (30 days out)

Step 2) Choose the strike closest to $213.94 market value, which is $214.00 in this case.

Step 3) Purchase the 2114.00 Nov 25th call option for $312 per contract

Step 4) Purchase the 2114.0 Nov 25th put option for $313 per contract

Total cost = $312 + $313 = $625 per contract. 

This represents the minimum account size you need to take a 1 contact trade.  If you want to do 10 contracts, it will cost you $6,250.  From here, it is all about scaling to your comfort and making sure you are risking 1% to 2% maximum for any given trade maximum.

When You Make Money – Trading Volatile Markets with the Straddle Options Strategy

Because the cost to buy directional exposure to the upside and downside is a total of $625, or $6.25 per contract, you need the SPY ETF to move at least this much in either direction within 30 days to break even on the straddle options strategy.

This is a 2.9% move ($6.25/ $213.94).  This shouldn’t surprise you, as you are expecting a big move to happen before choosing this strategy.  If you do not think it will move more than 2.9% in the next 30 days, you cancel the straddle options strategy and move to the next opportunity in another volatile market.

 

Here is the profit/loss diagram for the trade above:

spy-straddle-oct-23-2016

Notice that you need price to move above $220 to make money to the upside OR below $208 to make money to the downside.  The dotted line is the profit or loss on the expiry date, 30 days from now (Nov 25th).  The solid line is the price as of now, October 23rd.  The solid line will eventually turn into the dotted one, as time passes.

 

Another way to look at the straddle is:

1) If prices increase far enough, the call option gains will make up the losses for the put, and then some.

2) If prices decrease low enough, the put option gains will make up the losses for the call, and then some.

When You Lose Money – Trading Volatile Markets with the Straddle Options Strategy

You will lose money if the SPY ETF does not move at all and stays at the exact same price you initiated the trade by the 30 day expiry date.

This is because the call option and put option premium will essentially expire worthless.  This is called theta burn or theta decay.  This is the downside of the straddle option strategy.

If prices move up or down less than 2.9% before expiry, you will have partial loss.  You can look at the diagram above and approximate how much that loss will be by looking at the Y scale on the graph.

The maximum loss you can incur with the straddle options strategy is what you paid to initiate the trade.  This will only occur if markets don’t budge for 30 days, or go up 5%, only to drop and finish where they started by expiry.  The maximum loss happens very rarely with this strategy. (in 14 years, it has only happened to me 2 times!)

Risk Management Best Practices
The most important part of any professional traders plan is how they manage risk.

4 Rules to Manage Risk – Trading Volatile Markets with the Straddle Options Strategy

1) I close my trade when I lose 30% of my premium.  At this point I was wrong, the market isn’t moving fast enough.  I’m out. So in the above example, if straddle drops below $625 x 0.70 = $437.50, I cut my loss at -$187.50 and move on to another opportunity.

2) Alternative, I will close 50% of my position when I reach 30% profit, another 25% of my position at 60% and I’ll leave the remainder at break even until expiry.  If you only trade 1 contract, then consider taking profits at some point.  Never let a winner turn to a loser, ever!

3) Never buy straddles within 30 days of an earnings event or news release – the premium is already expensive at that point.

4) Buy earnings straddles 40+ days before earnings on FANG stocks (FB, AMZN, NFLX, GOOGL).

Converting a Straddle Options Strategy to a Directional Trade

The beauty of any options strategy is that once you initiate the trade, it can be molded to something different if your bias and expectations change, and they will.

Let’s assume you start with the straddle options strategy above, but:

1) After a 1% move up, you believe the market is going to trend higher – sell your put option and just hold the straight call.

2) After a 1% move down, you believe the market is going to trend lower and sell off quickly – sell your call option and just hold the straight put.

Just remember, if your bias changes, and you alter the strategy, your profit and loss will change.  Directional trades are more risky because you are making a bet on where prices will go.  The straddle just makes a bet that they will go somewhere.  That is a huge difference.  You should always know when, where and why you will get out before you get in or adjust.

Conclusion – Trading Volatile Markets with the Straddle Options Strategy

The straddle options strategy can be very profitable, especially when you expect volatile markets.  This strategy becomes very probable near support or resistances, as the supply and demand imbalances will send the market moving to the next target level quickly, which can generate some windfall profits.

Good luck and good trading, and remember to demo trade any new ideas before implementing them in your live account.

 

Sign up for one of our subscriptions and experience the edge of trading with the professionals.

For more information how to day trade successfully, click here.

To find out how to trade more passively with options click here.


The information contained in this post is solely for educational purposes, and does not constitute investment advice.  The risk of trading in securities markets can be substantial.  You should carefully consider  if engaging in such activity is suitable to your own financial situation.  TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.