Straddle is one of the key option strategies based on profiting from low or high market volatility. Option traders buy straddles if volatility is low and can increase in the near future. Short straddles can be interesting if volatility is extremely high and can decrease and / or the market can go into a flat. The essence of the strategy lies in the simultaneous buying / selling the call and put options on one asset with the same strikes.
Often there are situations when there is no definite trend in the market, the price is in a flat or triangle and it’s difficult to say for sure in what direction the market is likely to move further. However, a strong market movement is expected after breaking through the narrow price range.
In this case, the simultaneous buying call and put options can become a very attractive strategy. The portfolio formation that contains the positions allowing an investor to make profit during both market increase and fall gives him great opportunities to earn profit in the market. The feature of this combination is buying options with same strikes.
When trading straddles, implied volatility (IV) plays a key role. Long straddle becomes especially interesting when IV is at historical lows and can increase in the near future. Long-term LEAPS straddles with the maximum vega value are also attractive in this case, as the effect of increasing volatility on the option price in this case will be the highest. If implied volatility is at historical highs and may decrease in the near future, then short straddle may be attractive.
Suppose, we open long straddle by buying the call option for $14,5 and put option for $15,5 with $200 strikes. The total cost of the position is ($14.5 + $15.5) * 100 = $3000. Break-even point # 1 is at the price mark of $230 ($200 + $30), and breakeven point # 2 is at $170 ($200 – $30). Thus, we will make profit if the asset price leaves the price range of $170- $230 and / or if implied volatility actively rises. For example, if we buy an option when implied volatility is the lowest, then it increases by 10% next week, and at the same time our option position vega is equal to 0.5$, then we get 0.5$ * 10 * 100 = 500$ even if the market doesn’t move.
In anticipation of a sharp price movement in one direction or another after the breakout of the price range (often flats or triangles), in which the price has been for a long time, an investor looks at the market simultaneously in both directions, that is, he uses the long straddle option combination. At the same time in the expectation that the price will stay in this price range for some time, an investor will benefit from the short straddle strategy.