When it comes to trading, numerous strategies can be used with the aim of financial success. They (strategies) are designed to achieve profitable returns by either going long or short in the markets. For a strategy to be termed as good, it should be verifiable, consistent and objective.
What is a straddle?
This strategy is used when a trader is expecting the price of an underlying asset to fluctuate but he or she is unsure of the asset’s direction. By buying call and put options, day traders are able to benefit from price movements. One thing you need to note is that if the movement is large, the amount achieved from a single option will help to cover the purchase price of the other.
Here is a good example- You have a single stock being presented in the quarterly report. Since certain expectations must be met, the stock price may rise significantly. If the expectations are not met, the price will drop. When day traders buy a call and put option at the same price, both options will be covered.
Types of Straddles
1. Long Straddle
It is formulated around the purchase of a put and a call at the same strike price and expiration date. This strategy is designed to take advantage of market price changes since the market can move in three directions:
Side to side movement makes it difficult for traders to know if it will break up or down. To ensure success, there are two choices that can be implemented.
a. Traders have the option of selecting one side and hope the market favors them in the same direction
b. Traders can hedge bets and select both sides. This is how long straddle comes in.
The strategy is able to achieve this by exploiting increase in volatility. It will place you in an advantageous position regardless of how the market price moves.
Long Straddle drawbacks
a. Risk of losses
b. No volatility available
c. More expenses will be incurred
2. Short Straddle
Unlike the long straddle where the trader has to buy put and call at same strike price and expiration date, the short straddle calls for the sale of both put and call options at the same expiration date and strike price.
Thanks to this strategy, the trader will collect a premium as profit but the trade will only exist in a market with little or no volatility. What you need to note about short straddle is that if the market were to develop a bias in either direction, the premium collected will be at risk.
If the market does not move either up or down, the trader will be safe and if the market does not pick a direction, traders will have to pay for the accrued losses. They will also be required to give back the premium collected.
Using the straddle strategy
This strategy can work best if it meets the following criteria
a. The market should be moving sideways
b. Traders have extensive predictions of the market
Every binary option will allow you to make a single selection for your prediction in regards to the upcoming movement. This basically means that every trade will finish in or out of the money.
Since the straddle strategy is designed to cover both sides, you have a higher chance of making profits. One thing you need to remember is that it’s not a guarantee either of the two trades will be profitable. To straddle, traders have to select an asset and add identical trades using opposing predictions. One should be put and another should be call.
In order to complete the strategy successfully, basic math has to be used. This will allow you to ensure profits derived from a winning trade are used to cover costs of a losing trade. Here is an example to explain the above statement.
You want to trade a stock with $15. Your return rate is 80% and you hope one of the two trades finishes in the money. This shows that you will still lose money. If your investment is $30, your total profit would be $24. The only way to work around this is to invest more money.
If you were to invest $30 on the direction that you feel confident about and $10 on the option you are less confident of and your prediction is correct, your profit will be $48. Less the losing trade ($10) and you will have a profit of $38.
If the opposite were to happen that is $30 goes to the losing direction while $10 goes to the winning direction, the loss would be offset by the win.
That is how the Straddle strategy works.
As one of the most successful binary options trading strategies, it can be a useful tool helping traders to capitalize on select volatile markets and cushion potential losses on trades.
For the strategy to work, traders need to purchase different amounts of puts and calls with differing expiration dates and strike prices.