Straddle – Strategy to Know the Rhythm of the Market

Friday, May 17, 2013
Technically, a straddle is considered the purchase or sale of an equal number of puts and calls, with the same strike price and expiration dates. Realistically speaking, a straddle is a way to give yourself a choice. The most difficult part of trading is choosing whether you are going to be long or short; the second most difficult part is giving up that choice once it has been made.

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.

Market Specialist

Retail traders have a tendency to watch too many markets. They want to be involved with gold, oil, S&P 500, cocoa, lumber, euro, and so on, all at one time. This is counterproductive. Their reasoning is that they don’t want to miss anything. They simply do not see the material difference between gold and lumber or the euro and the yen. They are all interchangeable when it comes to opportunity.

Two problems arise when speculation is approached in this way. The first is that not all opportunities are created equal. By approaching gold the same way you approach wheat, you are ignoring several key factors. There is a difference in leverage, difference in fundamental factors, and a difference in volatility that affects each market.

The second problem is that you will miss opportunities by trying to watch everything at once. Computers have changed the life of the trader tremendously. Each trade setup can be programmed and the trader can be alerted to the setup. Unfortunately, as often happens, by the time you are alerted to the activity the move is underway and you are effectively chasing the market. Or you can be faced with too many choices, with little chance of discerning which one will actually take off and which one will not. This type of trade cherry picking can be frustrating and adds another layer of decision making that can cause trading hesitation.

The professionals that trade in the pits of the corn market only trade one thing and one thing only: corn. The professionals that trade in the pits of crude oil options only trade crude oil options. Many of them successfully earn a living focusing on one market. This can be replicated by retail traders. By focusing on one market, retail traders go from being just a trader to a euro trader or a wheat trader or an oil trader.

By becoming a market-specific trader you liberate yourself. Much like your current (or former) profession, there are trade journals, conferences, magazines, and seminars designed for these specific industries. Each is a fount of information that can give you fundamental knowledge and “public” industry secrets that you would not have access to as an average trader following a few signals.

Couple this additional knowledge with the prescient ability to understand a market’s rhythm, solely because you trade it exclusively, and you then begin to approach the same level of market savvy that professionals have. From this level of trading comes the ability to choose a day, swing, or position trade depending on the market’s needs, not your own.

Buy or Sell Side Specialist.

Who says you have to buy and sell? While it is easy to become caught up in buying stocks, few people ever short stocks. Many stock investors that come to futures or forex trading go to the extreme: they simply buy and sell too much. Since longs and shorts are treated the same when it comes to futures and forex, it is easy to get whipsawed in and out of positions.

If a trader finds himself losing money in his long position, they he may go short; if the short position is losing money, he then may go long. There are no rules against this activity and what many traders find themselves doing is chasing the markets. This constant chase generates commissions for the brokerage, not necessarily profits.

Not all signals are created equal. In a long-trending market, is shorting the best thing to do? In a short trending market, is buying the best thing to do? By limiting trading activity to the market’s most probable direction, you can develop a laser-like precision in making your trading decisions. You also learn patience.

All traders operate with a finite amount of capital. Whether it is a few thousand or a few million dollars, successful trading can only be achieved by limiting your trading activity to the opportunities that are most likely to succeed, not by taking every chance that comes your way. Not all opportunities are created equal.

It is said that trading is much like playing baseball, in that the more times at bat the more likely you are to succeed. If you swing at obviously bad pitches you will skew your batting average or even worse—strike out—unnecessarily. The same can be said of trading. Taking every buy and sell signal that comes your way is in no way superior to trading solely longs or solely shorts.

Technique Specialist.

Many professional traders come up with one or two techniques that help them trade the markets efficiently. The goal is to help them minimize their losses while at the same time maximizing their opportunity to profit. Sometimes the technique will be something as simple as selling options, other times they can be as complicated as butterfly spreads. No matter what the technique is there are always three components. First, a trading technique must have a built-in risk management component.

Selling options, you might rely on the fact that the majority of options that reach expiration expire worthless (approximately 75 percent). Or, on a spread trade, you limit your downside risk to the difference between a long and a short. Second, a trading technique must be able to be consistently applied to various trade and market setups. Finally, a trading technique takes account of capital appreciation as secondary to capital preservation. This is very important.

Professional traders have a fiduciary responsibility to their clients to preserve their capital, above all else. If they fail in that responsibility it prevents them from collecting incentive fees and will eventually halt their trading altogether. Retail traders should not take their fiduciary responsibility to themselves any less seriously. Published at:

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