Straddle Strategies: Smart Play or Risky Business?

Join Jeff Praissman as he sits down with Dmitry Pargamanik and Will McBride from Market Chameleon to explore straddle strategies in options trading. Are they a smart play or a risky business? Learn how volatility, time decay, and event-driven catalysts shape these trades.

Summary – IBKR Podcasts Ep. 317

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff Praissman 

Hi everyone. This is Jeff Praissman with IBKR Podcast. It’s my pleasure to welcome back to the podcast studio Market Chameleons, Dmitry Pargamanik and Will McBride. Hey guys, how are you? 

Dmitry Pargamanik 

Hey Jeff, thanks for having us. 

Will McBride 

Hey Jeff, always a pleasure. 

Jeff Praissman 

It’s always great to have you guys come in after your monthly webinar and do—I don’t know about deeper—but definitely a different dive on the subject matter. We just finished up a great webinar on straddles, and I think we should probably, for our listeners, start with the basics. The fundamentals: Could you explain to our listeners what exactly a straddle is and why it’s a particularly unique kind of strategy compared to some directional option strategies that many retail traders might be more familiar with? 

Dmitry Pargamanik 

Thanks, Jeff. A straddle is a strategy that involves two options. When we think of a call option, we think of a directional expression of a stock going up, right? So if you’re buying a call option, you’re looking at a directional type of trade. A put option is a trade that looks at a downside or bearish direction. But when we look at a straddle, we do both. A typical straddle is at-the-money, so you’re looking at strikes very close to where the stock price is. If you combine these as a strategy—buying a call and buying a put—you’re not looking at a directional bias but rather for movement. 

If the stock goes up and you’re buying a straddle, your call will gain in value while your put will lose. The stock needs to move enough to cover the cost of both options at expiration. Or it could move down, and your put will increase while your call decreases. So the stock has to move far enough in either direction to cover the cost of both options. 

Your call might be worthless and you lose everything on it, but if your put gains enough to offset that loss and more, then the strategy pays off. So when we combine those options, we take out the directional aspect and focus on the magnitude of the move. 

Jeff Praissman 

Volatility trading really seems to be at the heart of straddle strategies. How should traders differentiate between situations that call for betting on volatility expansion versus contraction? And are there market signals that typically indicate a potential volatility mispricing? 

Dmitry Pargamanik 

Great question—there are two parts to that. For volatility expansion, we’re looking at situations where our outlook is that volatility will increase. In that case, you want to buy the straddle if you think the implied volatility in that straddle is below your expectations. 

There are two ways to trade a straddle: 

1. Buy the straddle and hope for a move large enough to offset its cost. 

2. If you think volatility itself will increase day to day, you could trade using the Black-Scholes model—hedging your deltas daily and offsetting underlying trading versus option decay. 

On the other hand, if you think implied volatility looks high compared to your expectations of forward-looking volatility, you’d sell the straddle because you believe the premium priced into those options is too high. For volatility mispricing, part of the challenge is we don’t know future volatility—if we did, trading would be easy. But as traders, we try to model or use metrics to estimate future volatility. You can create your own forecast, and that’s where models come in. By comparing your estimates to market prices, you can determine if options are mispriced—whether they’re much higher or lower than your outlook. 

Jeff Praissman 

There are thousands of stocks and hundreds of data points. When you’re screening across this vast universe, what would you consider your top three filtering criteria to quickly narrow down the most promising opportunities? 

Dmitry Pargamanik 

Usually when I perform a screen, I have a thesis—something I’m looking for. Based on that, I use filters. For example, if I’m looking for earnings situations that might be particularly volatile, I’ll start screening options that cover earnings and compare market estimates to mine. 

Typically, there are common things I look for: 

• Liquidity: How much trading is going on around at-the-money options? This gives me an idea of volume and interest, which makes price discovery easier. 

• Bid-ask spreads: Narrow spreads make trading more efficient. 

• Upcoming events: Earnings or other catalysts that might impact the straddle. 

So liquidity and pricing are always important, and other filters depend on what you’re trying to find at that moment. 

Jeff Praissman 

We already talked about volatility being a big factor for straddles and one of the reasons you’d use them. Event-driven trading and straddles are really popular, especially around earnings announcements. Earnings announcements are consistent—every quarter companies announce earnings. That’s an event, but there are other events as well where straddles could be used. Could you talk about what some of these other events could be, and what sort of catalysts tend to affect volatility patterns both before and after the event? 

Dmitry Pargamanik 

Yeah, that’s good. When we look at options, one of the things that will impact volatility are those events. Like you mentioned, earnings—once a quarter, a company reports earnings, and we know that on an earnings announcement the stock has the potential to make a much bigger move than on a typical day because now you have material news affecting the stock price. But that’s not the only event companies may move on. There are investor relations meetings, annual meetings, and sometimes industry conferences where they might announce something about a product or management might give a forward-looking statement. 

Healthcare stocks often have periods where they release studies or hold PDUFA meetings with the FDA—those are large potential catalyst events. And sometimes economic events can move stocks. For example, when the Fed announces interest rate policies, FOMC meetings, or surprise inflation numbers—those can impact the market and move stocks in sympathy. So these are things to be aware of in your option pricing models or estimates. Some events are surprises, but many are scheduled—earnings, conferences, investor meetings, economic releases. You can get a schedule of these upcoming events so you can prepare appropriately. 

Jeff Praissman 

That leads me into my next question from two different angles. The concept of implied volatility versus historical volatility and percent changes. First, is there a range you look at when considering going long or short a straddle—comparing implied volatility to historical volatility? And then flipping that question: sometimes we all know earnings events and other scheduled events, but you just mentioned surprise events. I would assume there are times when the market is signaling something—pricing volatility higher—even when there’s no obvious news. Like, the volatility pricing is warning you: “Hold on, these straddles look a lot higher than they should be right now.” Maybe something’s coming that we don’t know about? 

Dmitry Pargamanik 

Exactly. One of the ways the market is helpful is the insight you gain from observing where markets are pricing forward-looking volatility. That’s a great question because stocks move at different volatilities, and they all have different implied vols. SPY has an implied volatility, Apple has its own, and so forth. To determine whether implied volatility is on the high or low end of the range, you have to compare it to that particular underlying’s historical implied vol. For example, if Apple’s implied vol is 30, you can look historically: if the range is 25 to 50, and X percent of the time it’s below or above certain points, you can figure out whether markets are pricing it on the low or high end. 

That’s important because if markets are pricing it on the high end and you don’t know why, the market could be telegraphing something. If there’s an earnings event, that makes sense. If there’s an upcoming conference with a possible announcement, that makes sense. But sometimes it seems high and you don’t see the usual reasons. That’s a signal to dig deeper. The market might be telling you something—maybe people are expressing an opinion that there’s more volatility or less liquidity coming in the underlying. That’s a heads-up for traders. So yes, you can look at markets not just for opportunities but also for signals about forward-looking volatility. 

Jeff Praissman 

That also leads to breakeven points, which are critical for straddle profitability. Whether you’re long and want to move past the breakeven point for profit, or short and want it to stay near breakeven. Let’s talk about short straddles for a second. They offer attractive premiums but come with theoretically unlimited risk—especially on the upside. On the downside, the stock could go to zero, so you’re stopped out. If it’s a $50 stock, you lose $50 minus the premium if it goes to zero. But on the upside, losses could be unlimited. What specific risk management techniques and position guidelines would you recommend for traders exploring short straddle strategies? 

Dmitry Pargamanik 

Great question. With a long straddle, you know your risk ahead of time—it’s what you paid. If you bought a put for $5 and a call for $5, your risk is $10. On the short side, you know what you could potentially gain—the premium you collected—but you don’t know your risk. You’d have to estimate it because unless you buy wings to cap your risk, if you’re just short the straddle, you don’t really know. 

So how do you manage that risk? You need to estimate whether the reward is worth the potential risk. There’s no perfect way because you’re running an estimate, so you have to create a model. A quick way is to shock the stock based on historical outsized moves. For example, what’s the largest move this stock ever made—25%? What if it did that now? Obviously, stocks rarely go to zero, so instead of assuming that, look at outsized moves typical for that stock and shock it. 

Jeff Praissman 

Like a realistic outlier move—maybe not “realistic” is the right word—but like a three or four standard deviation move? 

Dmitry Pargamanik 

Yeah, exactly. 

Jeff Praissman 

Real worst-case scenario that could actually happen versus, like you said, the stock’s not going to go to zero, but it might have dropped 25% a few different times over its life. And again, you don’t think it’s going to happen, but it could. 

Dmitry Pargamanik 

Exactly. So you’d want to see: what am I risking in that scenario? What am I risking if it moves one standard deviation, two standard deviations, three standard deviations? Where do I have to buy back that straddle versus what I sold it for? If I sold the straddle for $10 and then, let’s say, after a two-standard-deviation move I’m buying it back for $20, then I’m looking at a risk of $10 because I sold it for $10 and bought it back for $20. So you’re losing $10 to potentially make $10 in the best-case scenario where it goes to zero. So you do have to run a model—shock the stock—based on historical data or create your own estimate, like a 20% move. Then compare: at that point, what would I buy back the straddle for? What’s the loss? What do I think I have to gain if it stays within one standard deviation? Then create a risk-reward analysis that way. 

Jeff Praissman 

And time decay plays a big part in straddles. It works against long straddles but certainly benefits short straddles. How do traders balance the trade-off when looking at the time horizon—whether they have enough time for the move to materialize if they’re long the straddle versus minimizing exposure if they’re short and hoping it expires before busting through breakeven points? 

Dmitry Pargamanik 

That’s an important question. A straddle eventually expires, so you don’t have it forever. Options have time decay, meaning as you get closer to expiration, they’re worth less. Time decay isn’t constant or linear—it accelerates as expiration approaches. For example, with 30 days to go, you might lose 10 cents per day in time decay if nothing happens. But as you get closer, that might increase to 15 cents, then 18 cents. So time decay relative to option value isn’t linear. When you’re analyzing a straddle, you need to consider your outlook for that time period and how time decay impacts it. It’s tricky—there’s no right answer. The closer you get to expiration, the option is worth less, but a bigger move will make it go in-the-money faster. There’s a trade-off. You also have to consider other factors like implied volatility. For example, if an earnings event passes tomorrow and nothing happens, the straddle’s value will drop significantly because it was pricing in that event. So while theta gives an estimate of daily decay assuming nothing else changes, other factors—like volatility shifts—need to be considered. 

Jeff Praissman 

We’ve discussed a lot of quantitative factors today, but are there qualitative factors you consider before entering a straddle position? 

Dmitry Pargamanik 

Yes—events are a big one. The Black-Scholes model assumes the stock moves at some average volatility between now and expiration. But situations aren’t always like that. For example, if a stock is a takeover candidate and the price is $95 with a takeover price of $100, you’re not looking at daily volatility anymore. You’re looking at the probability of the deal going through or breaking apart. If it goes through, the stock goes to $100 and the options disappear. If the deal breaks, the stock might fall back. So you’re pricing options based on event probabilities, not historical volatility. The same applies to biotech companies awaiting FDA approval. If approval sends the stock from $10 to $30, or rejection drops it to $1, you’re modeling probabilities of those outcomes—not daily volatility. In these cases, you price straddles differently because the Black-Scholes assumptions don’t apply. 

Jeff Praissman 

Will, Dmitry, this has been great. Thanks again for coming by our studio. For our listeners, you can catch Will and Dmitry Monday through Friday on their YouTube channel right before the market opens. Also, on our website under Education, you can find past webinars and podcasts. Thanks again, guys—looking forward to next time. 

Dmitry Pargamanik 

Thanks, Jeff. 

Will McBride 

Thanks, Jeff. 

Jeff Praissman 

Yep.