Using LEAPS Straddles

Many options traders use straddles in order to take advantage of stocks that are about to get volatile. The strategy enables the trader to profit from the upside and the downside by simultaneously purchasing or writing a call and a put at the same strike price and with the same expiration date (usually both at-the-money). Learn how to use LEAPS to make this strategy work over the long term!

The strategy is perfect for risky, high-growth stocks like:

• Pharmaceutical Companies – A company that has a blockbuster drug in the later stages may see if fail and head to zero or succeed and hit the roof.
• Drilling and Mining Companies – Companies that are excavating or drilling in unknown places may hit oil/gold and make it rich or fail and head back down to zero.
• Activist Situations – Activist hedge funds may take action and push a stock towards a sale or they may fail and the stock may head lower under crappy management.

Unfortunately, there is no free lunch and there are several drawbacks to using straddles. The first is that it requires a lot of market timing – traders must know when the stock is going to hit its breaking point. Secondly, the implied volatility costs of these options are typically higher as many traders share you thinking. And finally, there is usually a high cost to exercising them early.

LEAPS can help reduce many of these risks by extending the time period during which these options can be exercised. Market timing becomes less important as traders now have 1 or 2 years to wait for the event to occur. Meanwhile, implied volatility lessened since the time frame is so long (although the time premium is higher).

Key Points to Remember

Professional traders and speculators both know about the events that are going to cause volatility in the markets. Therefore, the price of both put and call options should reflect the pending announcements and trade at a relatively high implied volatility.

It is very important to monitor your straddle position closely. After the big news is disseminated, the underlying stock will move but the options’ implied volatility premium will begin to drop. This means that holders of long straddles will have the combination of decreasing volatility and time premium decay working against their position.

As a result, most straddle positions are closed out ahead of expiration. It is advisable for many to immediately sell their position in order to take advantage of the short increase in implied volatility just after the move and escape the twin damages of decreasing volatility and time decay loss.

The Risks

The risk with any straddle strategy is that the underlying stock doesn’t move. In that case, the options will expire worthless (or be extremely undervalued) as the implied volatility and time premiums are lost. As a result, it is very important to make sure that you have a strong reason for price movement before implementing this strategy!

Conclusion

LEAPS straddles provide a great way to bet on a major FDA announcement, lawsuit settlement, new oil discovery or multitude of other things that tend to move the market. The key points to remember are to make sure it’s not costing you too much to get in and to make sure that you get out quickly while the implied volatility and time premiums are both still high!

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