Straddling Volatility for Profit

The U.S. stock market rises over time. It’s a fact. Unless you happen to have terrible timing, or you take many undue risks, if you are invested and stay invested for a long time, it’s hard to lose money in stocks. The question is how much return you earn.

In the short run, however, the market can fall. Sometimes, it can fall hard, and fast. If you have a long time horizon and you won’t need to tap your investment account for cash needs for a while, you should be fine. The market will come back unless the economy is permanently impaired.

For some investors who can’t afford to be patient, a roller-coaster market is a scary thing. It can lead to emotional trades, which usually don’t end well. Emotions and investing don’t mix well.

Viewing Volatility as Opportunity

Experienced traders, though, view increased market volatility (big ups and downs) as an opportunity. There are more opportunities to buy low and sell high. But it’s not easy to predict the market’s direction over a short amount of time. Fortunately, for option traders, there are strategies that can be profitable whether the market goes up or down, as long as volatility is high.

A long straddle is when you simultaneously buy a call and a put on the same underlying security and strike price. This strategy will be profitable if either the call or put gains enough to offset the premiums you paid to buy the two options.

For example, if you believe that due to economic and market conditions the S&P 500 will move by at least 5% over the next month, but you aren’t sure which way it will go, you could buy a straddle on the SPDR S&P 500 ETF (SPY).

You could buy the March 11, 2022 $440 call for $11.91 and put for $10.93, actual market prices as of market close on Friday, February 11. If you bought one contract of each, the total cost would be $2,284. (I am ignoring the commission cost, which should be negligible. At Schwab, for example, the cost is under $1 per trade.)

How the Gain and Loss Looks

The graph shows what your gain or loss would be at different prices for SPY if you held both legs of the trade to expiration. The premiums you paid, $2,284, is the maximum you can lose. If SPY ended up on $440 at expiration, then both options are worthless and you lose the premiums.

If SPY ends up at anything other than $440, either the call or the put will expire worthless, but the other leg will have value. As you can see, the more SPY deviates away from the $440 strike price, the better the return is for you.

The exact breakeven points are at $417.16 ($440 – $22.84) on the downside and $462.84 ($440 + $22.84) on the upside. Basically, SPY has to move enough for either the call or the put to be profitable enough to offset the total premiums paid. From SPY’s closing price of $440.46 on last Friday, this means that SPY would need to either fall 5.3% or gain 5.1% by expiration for the trade to be profitable for you—again, assuming that you held both legs through expiration.

Need High Volatility

Because you bought two option contracts, compared to when you buy only a call or a put, you will need SPY to make a bigger move in one direction to become profitable. However, the benefit is that you don’t need to correctly predict the market’s direction. You simply have to be right about the market making a big move.

Remember, the chart only shows what happens if you held both the call and the put to expiration. In practice, you are free to close out either leg or both legs of the trade at any time. For example, if the S&P 500 makes a big rally right after you initiate the long straddle, but you think it will fall back quickly, you can sell to close the call to take the gain while leaving the put open. If you are right and the S&P 500 does indeed fall, you can then close out the put too, and your total return would likely be higher than suggested by the graph.

The key point is that the long straddle works best in high periods of volatility where the market direction is uncertain. If you expect low volatility or if you feel strongly that the market (or a particular stock) will go in one direction, you’d be better off using another strategy.

Consider the proven options trading methodologies of my colleague Jim Fink.

Jim Fink is chief investment strategist of the elite trading services Options For Income, Velocity Trader, and Jim Fink’s Inner Circle. He has agreed to show 150 smart investors how his “paragon” trading system could help them earn 1,000% gains in just 12 months.

We’ve put together a new presentation to explain how it works. Click here to watch.