5 Reasons to Dodge Directional Risk

Did you know there's a way to profit with options that doesn't involve committing to a bullish or bearish stance? A strategy known as the "straddle" allows you to make money whether the stock moves higher or lower during the time frame of the trade. By purchasing both a call and a put on one underlying security, you stand to benefit, no matter where the shares are headed. To learn more about why the straddle is such a winning approach, read on.

Increase the odds of a winning trade. All other things being equal, a straddle is more likely to end up a winner than an at-the-money call or put. While a single-pronged directional options play offers a roughly 1-in-3 chance of yielding a profit, buying a straddle bumps up the winning percentage to roughly 42%. The basis for this higher win rate rests on a very simple concept -- since you've purchased both a call and a put on the same underlying stock, it's possible to make money no matter which direction the shares move. In other words, because you're "straddling" the bull/bear divide, you're just as likely to benefit from a major price plunge as you are a significant rally.

Lower the risk of a 100% loss. When you're playing straddles, there's a very low chance of experiencing a total loss. For this to occur, the stock would have to remain stuck squarely at the strike price of your straddle through expiration -- which would be a very unlikely situation, even in a fairly stagnant market environment. Typically, at least one of your options will expire with some intrinsic value. So, even if the shares fail to break through one of your breakeven levels, you can still exit the trade with at least a portion of your initial investment intact.

Take the pressure off your directional forecasting skills. Don't even worry about nailing the direction of the stock's next move. In fact, the straddle is best reserved for situations where you're completely uncertain as to where the stock is headed during the time frame of the potential trade. In other words -- these are not situations where you could see yourself comfortably buying a lone call or put, because you simply don't have that directional conviction. However, you should be confident that the stock is on the verge of making a volatile move, even though you're not willing to roll the dice with a one-sided bullish or bearish bias.

The straddle strategy also offers an even-handed way to trade around events without committing to a strict directional skew. For example, if a stock always seems to make a major move around the time of its quarterly earnings report — but the direction of that move is unpredictable from one event to the next — playing a straddle allows you to profit no matter how Wall Street reacts to the report.

Capitalize on expected volatility spikes. There are several technical and sentiment indicators that can tell you whether a stock might be on the verge of some major volatility. On the charts, it makes sense to consider equities that are going through a relatively quiet period of consolidation. This may seem counterintuitive, but sudden rallies and precipitous plunges are often preceded by unremarkable bouts of sideways price action. The most reliable indicators for trading straddles are tight Bollinger Bands, a symmetrical triangle, or any other sign of volatility compression that could precede a forthcoming surge.

From a sentiment perspective, high short interest can be the catalyst for major volatility. A flood of shorts piling on all at once can trigger (or exacerbate) a prolonged sell-off. On the other hand, a rush to cover by these bears could result in a sustained short-covering rally.

Reduce your reliance on stop-losses. With straddles, your dual directional exposure means you won't suffer major initial losses due to market volatility or adverse price movement. After all -- if one side of your trade is losing big, that means the other side is probably showing a decent profit. Plus, as mentioned earlier, it's very rare to realize a 100% loss on a purchased straddle. As a result, there's generally no need to make use of stop-loss or stop-limit orders to curtail your risk.

Anatomy of a Straddle

The long straddle is ideal when you’re not sure whether a stock is going to move higher or lower -- but you expect dramatic price action nonetheless. Maybe there’s an earnings report or product launch scheduled, or perhaps a biotech company is due to receive a key regulatory ruling. Or, after a long period of quiet consolidation, perhaps you think a particular stock is due to break out of its trading range.

To initiate a long straddle, you will simultaneously buy to open a call option and a put option on the same underlying stock. Both options will have the same strike price and the same expiration date. Most often, the focus strike price will be very close to the price of the underlying stock (or “at the money”).

Essentially, you are now long 100 shares of the stock (via the call) and short 100 shares of the same stock (via the put). In other words, you have a path to profit whether the shares rally or plunge during the time frame of the trade.

There are two breakeven levels on the trade, which are equal to the strike price of the purchased options plus the net debit (for a bullish move) or the focus strike less the net debit (for a bearish move). Profits are theoretically unlimited on a rally, while a sharp drop by the underlying stock can also reap healthy gains -- though "support at zero" caps the possible profit on the put option. The worst-case scenario would be for the stock to remain flat with the focus strike through expiration, which would result in a 100% loss.

Since you've purchased two options upfront instead of one -- and at least one of those options is likely to expire worthless -- the stock must make a fairly substantial move in order to offset your increased cost of entry and return a profit on the play. To avoid overpaying for options, measure implied volatility against historical volatility for a comparable time frame. For option buyers, it’s a red flag if implied volatility is significantly higher than historical, since inflated volatility levels result in higher option prices (and, by extension, wider breakeven rails).

 

Putting It Into Action With

Schaeffer’s Volatility Trader...

The strategy underlying our Schaeffer’s Volatility Trader recommendations is known as “buying straddles” - you create a straddle simply by simultaneously purchasing a call and a put with identical strike prices on the same security.

 

Creating and buying straddles is just that simple, and we believe participating in this strategy through our Volatility Trader service is a “must” for any investor with the goal of becoming a serious (and profitable) options trader.

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  • Detailed commentary outlining why we believe the stock and the recommended option have the fuel to generate sizzling returns for your portfolio.
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