Market Measures

Defining Straddles

| Oct 6, 2014
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    Market Measures

    Defining Straddles

    Oct 6, 2014

    When Implied Volatility (IV) is high, we will look to sell premium in order to take advantage of the volatility contraction. One of the best ways to do this is using a straddle option strategy.

    The straddle strategy is placed by selling an at the money (ATM) call and an at the money put. Using a straddle allows a trader to bring in a large amount of credit, which in turn extends your break-even points.

    The only downside to the straddle strategy is that you have undefined risk . This means that the trade requires a large amount of buying power as well as a potential for large drawdowns.

    In order to reduce our buying power and protect ourselves against a large move in the underlying, we can buy out of the money (OTM) options to define our risk and create what is known as an Iron Fly.

    To compare these two strategies, Tom Sosnoff and Tony Battista take a look at an in-depth study. The guys went back to 2006 to see how the two trades stack up in terms of profits, win rate, return on capital (ROC) and the largest drawdown.

    They found out that while you give up some profits, you are protected from the large moves. The largest loss on the straddle was over 5x that of the Iron Fly! This makes the Iron Fly a great trade for a smaller account because you use less buying power, increase ROC and avoid large drawdowns!

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