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Creating The Bottom - Part 1 of 2
We all know that we cannot pinpoint the bottom of a market. However, we can make a trade that acts as if we bought the bottom. That trade is called a biased straddle.
A straddle is nothing more than the simultaneous purchase of a call and a put, with the same strike and expiration, on the same underlying asset. It will make money if the underlying moves significantly up or down, and if implied volatility (IV) expands. It loses money if IV falls or the stock remains idle. The straddle, when created using at-the-money options, is said to be delta-neutral. That means, excluding the effects of IV and time decay, it profits equally from moves up or down in the underlying stock.
A biased straddle simply means that the position will make more money if the underlying moves in one direction rather than the other. This can be accomplished by complementing the straddle with shares of the underlying asset. So, if we start with a delta-neutral straddle and then buy ten shares of the underlying stock, we'll have a straddle with a delta of 10. That just means that the position will behave, initially, as if we owned ten shares of the underlying.
Let's say that we suspected the market was near its low. We could put on a straddle. If our timing proved to be off and the market continued its decline, the straddle could still make money - with regard to P&L, it would be as if we were correct in finding the bottom.
Now, there are some serious caveats that one must understand when it comes to straddles. Implied volatility plays a key role and is a significant risk if not managed well. Next week, we'll talk about how this position can surprise the trader with losses and how to mitigate that possibility. Well managed, straddles can be worthy vehicles. Poorly managed, and they can cost you a lot.
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Creating The Bottom - Part 1 of 2 
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