9 Rules To Pick The Best Straddle Option Strategy

How can you create a successful delta neutral strategy such as the straddle?

Down below, I am going to give an answer to this question by listing the 9 conditions and rules all traders willing to trade this powerful option strategy must follow. Respect these 9 rules to increase significantly your chances of success.

1. Pick at-the-money (ATM) options

Consider trading only ATM options trying to create a position as more delta zero as possible and keeping the two breakeven points at the same distance when the position is open.

2. Select options with 3 or 4 months before expiration

Consider options with three or four months before expiration. In fact, above 120 days options may be too expensive for a delta neutral strategy such as a straddle.

Conversely, below 90 days, you may have not enough time to be right on this trade. Remember that in a straddle time decay is against you, so you never want to own options in the last month before expiration.

3. Pick stocks trading within a price range

Select stocks whose price is higher than $20 and lower than $100. This may be necessary because a straddle is an expensive strategy and you want to avoid paying a high premium.

This is the range of price many professional traders recommend and that, in my experience, I have found more profitable and cheaper to trade. Anyhow, if you feel comfortable with, you can choose a different range of price.

4. Take notice of incoming news event

Any news or announcement that can have a relevant impact on the underlying security (e.g. earnings release, government reports, lunch of new products, new management, takeovers, etc.) are usually referred to as a catalyst event.

Rumors are around and may cause a rise in the trading volume of a stock, because of people expectations. People are expecting something to happen and this may have the effect to potentially determine a rise in volatility and an explosive movement of the stock. What you don’t know is the direction of such move. Even if the expected event didn’t happen, still there may be a consistent move determined by people disappointment or relief.

Straddle Trading Strategy - Market Catalyst

5. Pick options with low implied volatility

Look for stocks with low implied volatility as your goal is to purchase relatively cheap options whose volatility is about to increase. You can help youself by analyzing the charts of the implied and historical volatility in ThinkorSwim, Interactive Brokers or any other professional brokerage firm and compare their trend for the last year.

6. Check the mathematical feasibility of the trade

Before getting into the trade, consider doing a simple mathematical calculation to make sure of its feasibility. For instance, if you consider trading a straddle on options with 120 days left, you should go back 20 days for each month (in this case 80 days) and identify the stock high and low during this time (80 days).

At this point, the calculation to perform is the stock recent high less the stock recent low divided by two (high - Low / 2). In order to be feasible, the cost of the straddle has to be less than the result of this calculation.

7. Look for consolidation patterns

Perform a technical analysis of the stock. You don’t need to have a lot of experience on this, but a little is necessary as to identify patterns.

Find stocks that are experiencing a consolidation pattern such as pennants, flags or triangles. Or at least, you need underlying securities which are moving sideways with low implied volatility and that may have an explosive move.

Option Strategy Straddle - Consolidation Patterns

8. Don’t trade straddles too often

Look for stocks and options with high volumes and a consequent small slippage between the ask and bid price. Keep the price you pay low and avoid buying and selling the same straddle too often.

9. Utilize technical indicators

In order to trade a straddle successfully, you may found useful to use some momentum indicators. One I found by reading George Fontannils’ best seller “The Option Course” is the Average Directional Movement Index (ADX).

This oscillator measures the strength of a current trend and fluctuates between 0 and 100. Readings below 20 indicate that the stock is moving in a range; while readings above 40 indicate a strong trend in either direction.

Since you are interested in trading a straddle, you should look for a weak trend (lower than 20) and use the stock chart and the other selection rules to try to catch clues that the weak trend is ending and a strong trend is coming.

For instance, a stock whose ADX begins to rise above 20, may offer you a signal that a strong trend either upward or downward is approaching. On the other hand, if the ADX begins to decrease below 40 may indicate the end of a previous strong trend.