Best of Market Measures: On Straddles
May 28, 2015
In previous tastytrade blog posts, we have taken a rather in-depth look at the tastytrade approach to selling strangles and their defined risk cousins, iron condors. In those posts, we discussed how each strategy was set up and then how they are applied by tastytraders.
Today we will take the same approach to another tasty-favorite, the straddle.
A straddle is the simultaneous sale of the at-the-money (ATM) call and the ATM put. For example, if XYZ underlying is trading for 100, then we would sell the 100 call and put. If XYZ is trading for $99.76, we would likely still be selling the 100 call and put.
Let’s stick with this example, (XYZ trading for 100) and we sell the 100 call and 100 put for a $5.00 credit. This means we are short the 100 straddle for a credit of $5.00, our maximum profit on one contract is $500.
See the example below for $UPS:
That being said, the likelihood of being able to make exactly $500 on this trade is pretty slim, as the stock price would have to be exactly at $100 at expiration. If the underlying is trading for $99 or $101 expiration, the straddle would be worth $1.00, meaning we would have a profit of $400 per contract. In actuality, only one option is worth $1.00 and the other is worth squat! If the underlying is trading for $99 then the $100 put is $1.00 in the money, while the $100 call is worthless.
Let’s quickly compare straddles to strangles. Straddles are technically ATM strangles, given that both strategies deal with selling a call and a put around the current price. The main appeal of a short strangle in contrast to a straddle is the much wider breakeven that comes from having the strikes of the put and call away from the current price of the underlying. This wider breakeven comes with a higher probability of profit but a lower maximum profit.
As far as when we sell straddles, we have no hard and fast rules. Though the overarching guidelines would be the same as selling strangles, we look for underlyings with high implied volatility and high implied volatility rank. We may utilize a straddle in lower priced stocks, given that out-the-money (OTM) options that are away from the current price may not have a substantial amount of premium for selling a strangle. In these instances, we may look to sell the straddle and collect a richer premium.
Robyn recently looked at selling a straddle in a low priced stock on her weekly segment “I’m Ready To Start".
KEEP IN MIND:
Short straddles are definitely trickier than short strangles, especially when it comes to management. We may look to exit our straddles for a lower percentage of max profit than we would for a strangle, especially if we get a rapid decrease in volatility.
Now that we’ve gone over the ins and outs of short straddles, let’s take a look at some of the great tastytrade segments we’ve done over the past year regarding straddles. In this post, we will only look at Market Measures segments, so be sure to check out tastytrade.com for our straddle inspiration!
Starting off with a heavy hitter here! This awesome segment is jam-packed with 3 different studies, all of which build off one another. The first study looks at the comparison of buying and selling straddles on the S&P 500 ETF for the past 5 years. The numbers speak for themselves in supporting short straddles compared to long straddles.
The second study looks at the same straddles in $SPY, and analyzes profits and losses during the lifetime of the trade. We found that 89% of the trades show a negative P/L, at one time or another, before expiration. In 44% of the trades, we were able to manage the trade before expiration for a 50% winner.
The final study in this mega Market Measures looks at the breakdown of the straddle trades broken down by implied volatility rank. We find that selling straddles when implied volatility rank is above 50 yields far better results with smaller drawdowns and bigger winners.
Straddles typically take up more initial buying power to place a trade than strangles. This segment takes a closer look at return on capital on both straddles and strangles, and then also breaks them down by implied volatility rank. Don’t forget that the return on capital numbers we use look at profit or loss, as well as Initial buying power requirement.
This segment could get a little confusing, but it’s worth looking at! We looked at the one standard deviation strangle in $SPY every month with 45 days-to-expiration for 10 years. We used the credit of this strangle as our profit target for the straddle. It really makes a strong case for managing short straddles and shows how it can greatly increase our profit and probabilities.
This is a different approach to straddles; here we have an analysis of breakeven prices on short straddles and short one standard deviation strangles. We find that on average a short straddle brings in far more premium, with breakeven prices being only about 3% closer to the current price. Watch it here: http://ontt.tv/1C1I2iV
There you have it! 4 great Market Measures about straddles! Don’t forget to check out the rest of the tastytrade archive for more great discussion and content on straddles. If you have any questions for the research team on this, leave a comment below or email firstname.lastname@example.org!
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