Trading ETF Option Straddles

How To Play Volatility with ETF Options

Oil rig and pipeline at night
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There are many option trading strategies you can utilize to help increase the performance of your ETF investment. One such option investment tool is known as a straddle. A straddle is the purchase or sale of a call and put on the same strike price.

For our example, we will use the OIH (Oil Services ETF) June 80 line. Remember, a call is the right to buy a certain ETF at the strike price (in our example $80). And the put option is the right to sell an ETF at a certain price. We will set the June 80 call price at $2.25 and the June 80 put price at $2.50 and the OIH at $80.

Buying a Straddle

When you buy an ETF straddle, you purchase one call and one put on the same strike price in the same month. Using our example, if you purchase the June 80 straddle, you are buying the call and put on that line. The total price would be $4.75 ($2.25 call + $2.50 put). The goal when you purchase a straddle is for the underlying ETF to move. You don’t care which way it moves since you have both the call and put for upside and downside, you just want it to be volatile.

Sounds simple, but there is risk. Exactly $4.75 in risk, the price you paid for the straddle. In order for you to show a profit on this investment, you want the ETF to move, either up or down, more than $4.75. If the ETF stays between $75.25 and $84.75 before June, you will show a loss on this investment. However, if the ETF breaks either of these thresholds, you would show a gain on this investment strategy.

Options that are at the strike price have the most volatility since you are unsure which way the stock (or in this case ETF) will move. There is a 50-50 chance the fund will trade above or below that strike price.

In the case of a deep in-the-money strike price (for example the 60 strike) or a way out-of-the-money strike price (like the 100s), the likelihood is lower that the ETF will finish above $100 or below $60. Not that it can;t happen, but the chances are slimmer and that is why options at those strike prices have lower volatility.

Selling A Straddle

This is the opposite straddle trade. In this case, you sell one call and one put. Your goal here is for the ETF not to break the thresholds of $75.25 and $84.75 before June. The best case scenario is for the ETF to close at $80 exactly so that both the call and put have no value, but as long as the underlying ETF stays close to $80, the short straddle seller shows a profit.

As with any option sale, there is more risk than with the purchase of a derivative. When you purchase an ETF option, you are only risking the purchase price and your profit is unlimited (within reason) to the movement of the stock. When you sell and ETF option, your risk is unlimited, but your profit is capped to the sale price. While this seems too risky of an option trade, keep in mind that the cost of the risk is factored into the price of the option. The pricing calculation compensates you for the risk.

Trading straddles is considered an advanced option trading strategy, especially when you short the position, so it is very important to understand how it all works before you get started with ETFs. However, if you are well-versed in the world of derivatives, then straddle-trading is a great tool for when you want to take a position in the movement (volatility) of an ETF.

And for those investors who don't want to use options to play volatility, consider a volatility ETF that tracks the VIX Index.