Have you ever bought a call on a stock, expecting it to boom just after an earnings report, only to see it crash instead? The straddle option strategy is a perfect method for taking advantage of highly volatile markets, especially when it is hard to tell whether the market or your favourite stock is about to soar or is facing an imminent crash.
It is particularly useful during earnings season, or when a major economic announcement is imminent, especially for stocks that are sensitive to these types of reports.
Essentially a neutral strategy, it is more dependent on large movements in the market than it is on direction.
What is a Straddle Option Trade? A straddle options trade involves the simultaneously buying of a put and a call of the same underlying stock, strike price and expiration date.
You would buy one ATM (At-the-Money) Call and one ATM Put.
The idea is that when the stock makes a big move, either up or down, one of the options will end up worthless, and the other will be sufficiently profitable to cover the loss of the "failed" leg.
A useful factor is that when a stock suddenly surges, it often just as suddenly crashes, and so you can reap profit first from one leg, and then a few days later, from the other.
The advantages of a Straddle Option Trade

• you can profit from this trade if the stock moves in either direction;
• the potential profits can be huge on both the upside and the downside;
• your maximum loss is limited to the cost of your position;
• if volatility is low when you purchase, and rises, both options can profit without much change in the option price (especially in the run up to a newsworthy report).
  

When to use a Straddle Option Trade

• you would normally place a trade about two weeks before an earnings report or major economic report that has previously had a significant effect on the price of the stock;
• you would buy options that have at least six weeks left to go before expiration, so that your option value is not dramatically diminished by time decay;
• you would choose a stock whose historical volatility is relatively high, and whose implied volatility is lower than the historical volatility, so that the options are relatively cheaper than they have been trading in the last months.
  
• you would look for price consolidation patterns in your technical analysis, such as pennant or triangle patterns;
• you would trade stocks that are higher than $15 in value, so that you enough potential downside for a balanced trade.
  

Exit Strategy Look to exit soon after your anticipated news event.
If there has been little movement after the event, sell reasonably quickly so that you don't lose out to time decay.
Or, if the expected price jump happens, sell the profitable leg at your predetermined profit target, but keep the other leg for now.
For example, if the stock jumps up in price, the call will become profitable and the put will be almost valueless.
As long as your call profit is higher than your total original debit (cost of both the call and put together), you can take your profit.
However, sometimes the stock swings back down again as others take their profits, or as the market corrects its over-reaction - at this point your put may also end up profitable!! In any case, ALWAYS sell both legs of the straddle a minimum of one month before expiration.