For the past few weeks, we’ve been telling readers about options strategies designed for traders who want to step up their game. That means we’re going beyond explaining simple strategies like selling puts or buying covered calls.

Today, let’s address what’s known as a “combination trade.” This is an options strategy where the trader takes a position in both call and put options in the same underlying stock. Specifically, we will look at a popular trade called a long straddle.

In this type of trade, an investor will purchase calls and puts on the same stock with identical strike prices and expiration dates.

It may initially sound counterintuitive to be on both the long and short side of the same stock. If you’re only trading regular common stocks, it doesn’t make sense to simultaneously be long and short. But when it comes to options, it is sometimes beneficial.

Let’s dive in and learn more…

How A Long Straddle Works

Straddles are designed to allow investors to profit from a large move in a stock. The beautiful thing is that the stock’s actual direction does not matter. The only thing that matters is whether the stock makes a substantial move.

This is the key point to trading straddles. You don’t have to be sure which direction the stock will move. You just have to be sure it will move powerfully one way or the other. Because of this, straddles are an excellent choice in choppy markets where the only certainty is high volatility.

Let’s look at an example of how a straddle trade works…

Let’s assume that XYZ is currently trading at $100 per share. Due to a significant event that will occur soon (an expected news event, earnings release, product release, etc.), a trader might believe the stock will move at least 10% in either direction. In this example, let’s assume that the XYZ 100 put options and XYZ 100 call options are trading at $3 each.

To trade this, you could enter a straddle trade by purchasing the XYZ 100 put for $3 and the XYZ 100 call for $3 (for $6 out of pocket).

As you can see in the payoff diagram above, this particular straddle will be profitable if the stock price moves more than $6 in either direction by the time the options expire.

If the price remains at exactly $100, the trader will suffer a maximum loss of $6. Once the price of XYZ’s underlying shares moves beyond $94 or $106, the investor will begin to realize a profit. If the price moves at least 10%, as the investor predicted, to $90 or $110, then the profit will be $4 ($10 sale of option – $3 purchase of call – $3 purchase of put).

It’s important to remember a few things when using this strategy. First, options tend to gain value faster than they lose value. So, any move (bullish or bearish) will increase the straddle’s value. But, whenever you buy options, you are vulnerable to time decay. This is especially true when it comes to straddles. It’s also important to remember that time value doesn’t decay consistently. It tends to accelerate in the last two months before expiration, so it’s a good idea to close out of your position six to eight weeks before then.

Action To Take

With some planning and practice, you can use the same techniques professional traders use to earn above-average profits.

The two strategies we’ve discussed recently (spreads and straddles) can limit an investor’s losses. Yet, they still allow you to realize significant gains.

By using multiple option positions simultaneously, you can create powerful tools to help you earn greater returns and manage risk in your portfolio. If you’re interested in this strategy (or any other advanced strategy we’ve discussed), consider placing a few practice trades. Then, if you feel comfortable, try them out with your portfolio. You may be surprised by the results.

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