The next trade in our discussion of option spreads is the “straddle” in which we simultaneously buy or sell a call and a put with the same strike price and expiration date. The trade is typically initiated when the options are both close to at-the-money.

If you buy both options, you are said to be long the straddle and if you sell them you are short the straddle.

A long straddle benefits from two things – movement in the underlying away from the strike (actual volatility) and an increase in demand for options (implied volatility.) If the underlying fails to move, the prices of the options decays as time passes, reducing the value of the spread.

As you might expect, the short straddle has exactly the opposite characteristics. As time passes without movement in the underlying or if implied option volatilities fall, the short straddle is worth less – resulting in profits for the seller.

So if you believe a stock is going to move, but it could be in either direction, you’d buy a straddle. It’s a limited risk trade and the maximum loss is the total premium you paid for the two options. If the stock moves away from the strike by an amount greater than the premium paid, the trade will show profits. The maximum profit is unlimited to the upside and limited to the difference between the strike price and zero to the downside.

Or, even if you’re not sure whether the stock will actually move but you feel as though the options are relatively cheap on an implied vol basis, you might buy a straddle on the expectation that the options market demand will cause options prices to rise, increasing the value of your position even in the absence of actual movement.

We’ll keep using Disney (DIS Quick QuoteDIS - Free Report) options.

Example: Buy one DIS September 145 call @ $4.40 and buy one DIS September 145 put at $4.70. These options have 50 days to expiration. They’re currently priced at an implied volatility of just over 21%, which is fairly low for an individual equity.

The p/l profile of the trade looks like this:

Disney is a large cap company with consistent financial performance and extensive analyst coverage. Large unexpected moves are relatively unlikely, so the implied volatility of the options is low. If the shares move more than $9.10 in either direction between now and expiration, you’d have a profitable trade, but that’s not the only way to make money.

If implied volatility rises to 25%, each option in our straddle will increase in value by about $0.80 – and our straddle will increase in value by $1.60. We can sell it rather than holding it to expiration and lock in that profit.

(You use the calculator at optionseducation.org to analyze the prices of these options. I recommend experimenting with the values of options as the inputs of time and volatility change.)

Keep in mind though that time is not on our side in this trade. At the original prices, each option decays about $0.05 per night, so if nothing happens in the underlying or implied volatility, we lose $10/per night, per spread.

The time decay increases as expiration approaches. (The rate is the inverse of the square root of the amount of time remaining, if you’re interested in the math.) With 25 days remaining, the straddle will lose $0.15/night and with 5 days remaining it will lose $0.33/night.

Most retail traders will be uncomfortable with the unlimited risk aspect of selling a straddle, but just for comparison purposes, the profit and loss potential are the exact mirror image. The seller of a straddle profits when time passes without movement in the underlying and when implied volatilities fall.

As you might expect, implied vols tend to rise as a scheduled significant event (like an earnings announcement) approaches and fall after the event has occurred. They also rise in response to a company announcement that adds uncertainty to the share price.

In the case of mergers and acquisitions, implied volatilities tend to collapse to near zero. It’s hugely unlikely to actually happen, but if another company issued a cash tender offer for Disney, the share price would go to something fairly close to the offer price (the difference representing the degree of uncertainty of the deal being completed) and the implied option volatilities would go to something very close to zero – again with the remaining premium representing uncertainty that the merger will close.

One Final Consideration – Historical vs. Implied Volatility

In general, because more market participants choose to be long options than short, implied volatilities tend to be a bit higher than the actual observed volatility of the underlying. The amount varies, but over long periods of time, it has generally been in the area of 2% higher in volatility terms – meaning that for options priced at 21%, the average movement in the shares over the life of the options is usually closer to 19%.

This premium is not insurmountable if you have an effective thesis for why the underlying is more likely to move than option prices would suggest, but it’s worth noting that supply and demand concerns mean you have slightly less margin for error when you are a net purchaser of options in a spread than when you are a net seller.

Next Week: The “Strangle”

-Dave

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.