Straddles, like all of the other strategies, teach you to be aware of the rhythm of the market. You learn how to put the reality of the market ahead of your desire to see the market do what you want it to do. This is essential to succeed in trading. When you decide to execute a straddle you are leaving your choice of market direction up to the market itself, as it should be. You then are required to cut off the less profitable position immediately. It is well worth the expense of the straddle to learn both these lessons.
Straddles teach you how to:
1. Let the market decide the direction it wants to go in
2. Cut losing position immediately
3. Focus on the benefits of risk management, not expense
Don’t be fooled into believing that you cannot afford to put on a straddle. If it is the best choice for the situation, then execute it. If you are an active trader or a day trader, a straddle may be the perfect solution for you to achieve your goals. Whether it is a Fed announcement, Consumer Price Index report, or jobless claim numbers, it can be very difficult to get a bead on the market’s intended direction. So instead of forcing an artificial or rumored direction on your trading, use a straddle to establish your initial position.
From there you can do one of two things:
1. You can close out the losing position and ride out the profits from the winning position before the end of the day.
2. You can hold on to your winning position and convert it from an active trade to a position trade.
Either way you come out ahead of the person who simply guesses or predicts the market’s direction and has a 50/50 shot of getting it right. Does the person who guesses the market’s direction have the ability to make more money? Of course! If he guesses right, there is no losing trade that eats away at part of his profits. On the other hand, it is an all-or-nothing proposition. If he guesses wrong,, there is no profitable trade to pick up the slack.
The question to ask yourself as a trader is whether you capable of trading with a 50/50 level of certainty or if you want the protection afforded to you that hedging your bets can offer. As with all the risk management strategies throughout this article, this one is not designed for everyone. In fact, not every strategy is designed for every situation.
The straddle works best when it meets at least one of these three criteria:
1. The market has been moving sideways for sometime
2. There is a news, earnings, or government announcement
3. Analysts have talked up the figures of a potential announcement excessively
For those who are new to trading, the last criteria may be a little difficult to understand. Those who have trading experience will comprehend this quickly. Prior to any earnings decision or governmental announcement, analysts will do their best to predict the announcement. They will make estimates weeks in advance of the actual announcement. This has the affect of making the market move. Whether it’s right or wrong is secondary to the market’s activity.
Once the actual numbers are released, the market has one of two ways to react. It will proceed in the direction of what the analysts predicted or it will show signs of fatigue, because the analysts were in line with what was expected; profit taking will ensue and the market will suddenly move in the opposite direction of what the news portends.
If the news was bullish, but the analyst had already predicted that, and the market had already made gains up until the announcement, then we could see a quick selloff. The identical behavior occurs if the news is bearish. The difficulty occurs in determining when the market will move counter to the news and when the news will simply add to the momentum of the market’s direction.
The straddle protects you from what you don’t know, or what you can’t know as a trader. This is a big feat to accomplish in such a simple package. Yet for all of its positive benefits, the straddle comes with a significant drawback: price. The most effective straddle is accomplished when you are able to purchase a put and call option “at-the-money.” Since at-the-money options typically follow the underlying asset practically one-for-one, they can be the most expensive to purchase. This also means that once the market decides on a direction, the losing option begins to erode in value quickly.