You know that company X is reporting its earning tomorrow before market open tomorrow, and from the past history results you know that the earning results will drive the stock movement drastically. But you do not know whether it will beat the earning estimated by the analyst or not, though many said yes, but the bad market situation now could impact the financial results of the company as well. You have no clue how is the results likely become, but you know one thing, the stock will swing a lot after the result is announced, therefore you set up a straddle options strategy. Hoping that the stock will make huge move and you will reap some profit from the trade.   

source: shoofy stock  used under: CC

Straddle is one of the most popular volatility strategies, to set it up, you simply buy the call and put at the same strike price with the same expiration date.

Volatility strategy is applied when you wish to make a profit whether the stock moves up or down, you simply don’t care where is the direction of the stock, but it needs to be impulsive move.

How to Set Up a Straddle Strategy:

1. Buy a call of company A at strike price B and expiration date of C
2. Buy a put of company A at strike price B and expiration date of C

Doesn’t it sound too simple?

Steps:

-          Look for stock that going to make any news announcement soon like earning report, merger and acquisition news, trial case, and etc. You can set up this strategy 1 week before or 1 day before the news release, depends on situation

-          Observe the stock pattern before the news release, if it has been too volatile, this strategy may not be effective as you may be buying high price options.

-          You are looking for low implied volatility options when you are buyer, if the stock move explosively, the implied volatility is high and it will drive one of the options price higher, and you earn from the difference.

Things to watch out:

1. If the stock moves side up, your option price will fall by the time decay when it near expiration date, the time is decreasing and you will incur a loss at the end of the day.
2. You need to buy at the strike price that closest to the current stock price, the best case is ATM – at the money.
3. Find stock that at the range of above 30 or below 80, options with high strike price has very high premium which sometimes is hardly affordable.
4. Set up the straddle only when big things is happening soon, of course, those that you are aware of, like earning report, fed announcement, or any news announcement that impact that particular company share price.
5. Set up the strategy with options that is 2 months away from expiration, preferably 3 months, so that you have options contain better time value.
6. Exit the trade if the news does not really impact the share price, either in positive or negative way.
7. Find stock that is forming a consolidation pattern, because it has lower volatility, the options premium will be cheaper when you buy them. If the stock has been volatile before the news, the option premium may become high, the options premium may suddenly drop a lot after the news is released, resulted in loss.
8. Take note of the bid/ask spread, if the gap is too wide, the set up will be not effective as well. This is normally due to the low liquidity that leads to low open interest.

Exit Strategy:

I would recommend exiting the strategy by selling both the call and put together. Some people like to catch the reversal and hoping to reduce the loss of the remaining option, this is possible, but quite exhausting, and the trend most likely continue after the news is made. 

Risk:

Your maximum risk is the premium that you purchase the call and put options, therefore it is capped.

Reward:

Your maximum reward is uncapped, because the stock can jump up to sky high or drop to bottom.

Disadvantages:

-          Straddle can be quite costly as you need to buy both the call and put at the same time

-          Significant movement of the stock is required, if the stock moving sideway or range bound could cost you money by eating up the time value of the options.

-          Both the call and put options premium may suddenly drop drastically after the day the news is announced, this is because people are no longer excited by it, and the volatility has dropped.