An attractive feature of trading options is that a trader can limit their risk in search of trading profits no matter which way the market is heading. An options trading strategy that provides this opportunity is called the long straddle. There are times when the market is very volatile and when it is not clear which direction prices will move next. When this is the case, a long straddle provides profit potential whether prices go up or down. The long straddle consists of a call and a put, both for the same stock, the same expiration date, and the same strike price.
When a long straddle is set up the trader pays for two premiums, one for the call and one for the put. In the case that the stock price continues to trade sideways during the duration of the options contracts the cost of this setup is two premiums plus commissions and fees. The disadvantage is that the trade loses money but the advantage is that the loss is limited to the cost of setting up the trade. There are situations in which a stock price could move dramatically in either direction, and not simply remain flat.
One example for when a long straddle could be employed would be for a biotech or pharmaceutical company with a potential blockbuster drug undergoing clinical trials with the Food and Drug Administration. If the drug passes its current stage of testing the stock price is likely to soar. If the drug fails to pass the stock price will fall precipitously as this is the only drug the company has in its pipeline. While traders can speculate on whether or not the drug will pass or not, the nature of modern double blind drug studies is such that there will be no leak of information prior to final test results being announced. Thus the stock price will bounce up and down in a given trading range based on pure speculation prior to making a major move up or down.
One might think this approach to options trading covers all the bases and is, as such, always a good approach. However, the cost of setting up this trade can eat away at potential profits if it is used when the stock price is not likely to move very much or very often. Each time this trade is set up it costs money. If a trader has a good idea that the stock is far more likely to move up than down or vice versa then simply using a call of a put cuts the up front cost of the strategy in half. One way to cut down on the cost of setting up this strategy is to buy out of the money puts and calls which means going with two different strike prices, one far below the current stock price for the put and one far above the current stock price for the call. In such a setup the cost of the setup is less but it will take a much larger move of the stock price either up or down to make the trade profitable. Thus, a trader needs to pick and choose when to use this approach and only apply it to situations in which dramatic price movement is very likely in the near term.
At Maverick Options we advise traders to always hedge their risk. This strategy does that because the worst-case scenario is the cost of two option contracts and no more. Picking the right stock in the right situation for a long straddle is a skill that traders learn with time. By signing up with one of the trading squadrons at Maverick Options a novice trader increases their odds of picking the right trade at the right time to apply this and many other options trading strategies.