If you think a stock is due to make a big move either to the upside or downside but don’t know which way it could break, a straddle can allow you to take advantage of that implied volatility. Typically, a long straddle involves buying an at-the-money call and an at-the-money put, thus straddling where the stock currently is trading.
Kearney uses the example of a stock trading at $50 going into an earnings report. Although he doesn’t know if it is going to do well or poorly, he expects there to be an outsized reaction to earnings, so he initiates a straddle by buying a 50 call and a 50 put. “Hopefully the stock goes to either $80 or $10. If we go to $80, then my put is worthless, but my call is $30 in-the-money; if we go to $10, then my call is worthless, but my put is $40 in-the-money,” he says.
A straddle makes the most sense if you think something exceptional is going to happen, but that implied volatility already likely is high, which would make the at-the-money call and put fairly expensive. “The market isn’t stupid,” Burgoyne says. “Especially with companies that don’t manage their expectations with the street very well, the market expects a big move so the [implied volatility] will go up in advance of earnings.”
Anything less than a 10% move can cause a loss because the position is so expensive to put on. Your maximum risk is right at the strike price. If in our example the stock only moves to $53 or $46, we may get $3 or $4 back on a position that may have cost $5 or $6 to initiate. If it works in your favor, though, the potential profit is open-ended.
A straddle would have worked very well for an investor going into Apple Inc.’s (AAPL) first quarter earnings report. The stock closed at $514 on Jan. 23, 2013, and options prices indicated investors expected the stock to trade in a $32 range the next day. AAPL opened the next morning at $460 and closed the day near $450. A straddle on the 515 strike would have done very well.
Although you also can initiate a short straddle by selling a call and a put if you think the stock is likely to stagnate, Kearney says most beginning investors may not be approved by their brokers for the strategy because it would give you unlimited loss potential on the upside or the stock “could get clobbered on the downside,” resulting in massive losses.