What is a Option Straddle?

Option Straddle

A long Straddle involves buying a call and a put at the same strike price and same expiration month. The total cost of the position is reduced when volatility is low and strike price is near stock price. Risk is limited to total cost of position.

Let's look at the long straddle trade entered on March 22, 2006 on Aztar Corporation (AZR). AZR closed at $39.25 on March 21st. The Nov $40.00 strike call was $0.75 and Nov put was $1.70. Implied volatility on that day was 21.57% and at the 0.94 percentile (extreme low). The profit graph for this position is shown below.

Note that there is unlimited profit to the up and down sides. The recommendation on this trade was to buy 12 calls and 12 puts for a total cost of $3000.00.

The trade report shows the probability of profit at several percent profit levels. On a straddle trade, the profit is cost multiplied by percent profit. For a percent profit of 20%, this would be $600.00 on this trade ($3000 x 0.20 = $600).

We calculate the probability of achieving 20, 50, 100 and 200% profit on straddle trades we test each night. If the 20% profit probability is 95% or greater we recommend the trade. Our target percent profit is 10% or greater and we risk 90% of the entry debit. After 10 days in the trade, we bail out at break even or any profit. On straddles we limit total risk to about $3000.00 per trade. Using our trade management tool, you can test your own method to manage trades.

In the case of this AZR trade the probability of profit at 20% was 100%, 50% was 100%, 100% was 100% and 200% was 89.91%. Since the 20% profit level had a probability greater than 95%, we recommended this trade and targeted 10% profit. This approach gives us an extra chance of success.

On the morning of March 22, 2006, the options were actually priced at $1.50 for the calls and $1.50 for the puts. Since this would be a cost of $3,600.00, do we go ahead and take the trade? To determine this, we calculate the probabilities again and take the trade if probability is still greater than or equal to 90%. In this case, it was and the trade was entered; however the number of options traded was 10 instead of 12 in order to limit risk to $3000.00.. The 10% profit level was $300.00. The trade was closed on March 30th with $400.00 profit or 13.3% profit.