Time Decay, Bid/Ask Spread and Breakeven Points in a Straddle Option Strategy
There are three aspects that can dramatically affect the success or failure of a straddle and that cautious traders should always take into considerations. These factors are:
Time Decay Effect on a Straddle
In a long straddle, you are buying ATM options far from expiration (around 90, 120 days) and, as a consequence, carrying a certain time value measured by the Greek Theta.
As time go through, options are going to lose a significant part of their value. For this reason, you need the underlying to move quickly and significantly as to recover the value that is being lost.
Time decay hurts long options because time value gets lower as options get closer to expiration. Since time decay accelerates exponentially during the last month before expiration, you absolutely don’t want to get stuck into a straddle.
Your aim is to earn from an explosive move of the stock, while taking into consideration that Theta is negative and, consequently, the passage of time is harmful to your position. In such a situation, you make a profit if the stock moves up or down considerably and you make a loss if the stock doesn’t move at all.
Time decay affects your position negatively when it is unprofitable (stock price close to options strike and within the two breakeven points). On the other hand, the effect of time decay becomes less negative and then totally ineffective on the trade when the position is profitable (stock price much greater or smaller than respectively the higher breakeven point or the lower breakeven point). An unprofitable straddle, having a negative theta, will be becoming more dangerous as it approaches the expiration date.
Bid/Ask Spread Effect on a Long Straddle
The good news about bid/ask spreads on options is that volumes have increased substantially in the last decade making options trading consistently more affordable than before.
Despite this fact, it is still true that generally bid/ask spreads on options are larger than they are on stocks due to the lower liquidity of the overall options market.
When you trade a straddle, as an option buyer of both calls and puts you expose yourself to a higher bid/ask spread making your overall position more expensive.
In fact, trading a straddle involves buying options at a slightly higher price (asking price) and, being all equal other conditions, selling the same instruments at a lower price (bidding price).
As a result, if you trade straddles too often, the high spread can make your position riskier and eventually make you lose money. That is why it is not recommended trading this option strategy too frequently.
Straddles and Breakeven points
In a straddle there are two breakeven points (BEPs), the first in the downside and the other in the upside. Your trade is unprofitable within the breakeven points and becomes profitable if the stock rises above the higher BEP or falls below the lower BEP. The two breakeven points are calculated as follows:
Breakeven Up: ATM Strike + Net Debit
Breakeven Down: ATM Strike - Net Debit
For instance, imagine opening a straddle on a stock traded at $87,50. Let us suppose that the two BEPs are respectively at $78,24 and $96,76. These are the BEPs at the expiration date. It means that the stock should drop below $78,24 or rise above $96,76 by expiration, if one wants to make a profit.
In reality, the ATM options purchased carry a certain time value that makes their BEPs at the current date tighter than the ones at expiration. As a result, your BEPs at the date you close the trade will be easier to reach, because you never have to hold this strategy until expiration. This situation might allow one to get a certain profit depending on the amount of time value still contained in the options owned.