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Using Calls and Puts
by Optionetics.com
Wednesday, December 30, 2009By Jody Osborne
www.optionetics.com
One of the greatest advantages to using options is the flexibility they provide. Dozens of option strategies can be implemented that can profit in any kind of market environment. This flexibility just isn't available when trading stocks. For example, what if we see a stock that has been consolidating, but we expect it to move sharply in the near term. However, the direction of this move is hard to determine. This makes it difficult for a stock trader, but easy for an options trader. This is because an options trader can buy both a call and put and can profit if the stock moves in either direction.
When a trader buys a call and a put using the at-the-money [ATM] strike, it is called a straddle. A new option trader will ask how it is possible to make money using both a bullish and bearish option. It is obvious that a stock trader can't make money by going long and short the same stock. However, options are a different animal and a straddle is a very viable and oft used strategy in the options arena.
Options are derivatives of the underlying security, which means they derive their price from the movement of the stock. However, implied volatility is also a large part of an options price. A straddle is often referred to as a delta neutral trade because if we combine the deltas of the call and put, it equals zero. However, as the stock moves in one direction or the other, the gains usually outpace the losses. In fact, a straddle is an unlimited reward strategy.
The total risk we have when buying an option is the price of the option. However, the reward is unlimited and this means that at some point in time, the gains from the winning side could be larger than the max loss on the other side. The main risk when trading a straddle is a lack of movement over time. If the underlying security just sits still, the options will lose value and a loss will occur. Even on smaller moves in the stock, a straddle can still become profitable. This is why a straddle, and its sister strategy, the strangle, are popular option strategies.
Take the time to run some risk graphs using these two strategies to see how they work. Just remember that we are buying two options, so it is wise to use options that are showing low implied volatility [IV] relative to past values.
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