Straddles and com-binations are volatility trades unique to the options market.

A straddle or a combination is profitable if the underlying security trades inside (if you are selling a straddle or a combination) or outside (if you are buying a straddle or a combination) the trading bands, which are defined when the position is established. There is no other market in which you can take a position that does not require you to forecast the direction of the underlying security.

A long straddle involves the purchases of a call and a put on the same underlying security with the same strike price and expiration date. For example, if XYZ is trading at $50 a share, a straddle would involve the purchase of, say, the XYZ March 50 call at $2 and the March 50 puts at $1.75, for a net debit of $3.75 a share ($375 per straddle).

By purchasing both a call and a put, the direction in which the underlying stock moves does not matter. If the stock rises, the calls will profit. If the stocks falls, the puts will profit. It’s a no-lose proposition — if not for the fact that when one side of the trade wins, the other loses. It’s problematic in that when the calls are rising, the puts must be falling — and vice versa.

When buying a straddle, you want the stock to move beyond the parameters established by the straddle. The parameters are the net debit paid, which is $3.75 a share in the XYZ example. This means that XYZ must be above $53.75 or below $46.25 at expiration for the position to be profitable.

The combination is also a volatility trade. The difference in this case is that the call and the put have different strike prices. Keeping with the XYZ example, you could establish a long combination by purchasing, say, the XYZ March 55 call and the XYZ March 45 put. The advantage is a lower up-front cost with the net debit for the XYZ combination. The March 55 call and 45 put combination could probably be established for a $1.50 a share debit, vs the $3.75 a share debit for the XYZ 50 straddle.

On the other hand, the range of possibilities also expands. The underlying stock has to move more dramatically in order for the position to be profitable. And there is also a greater chance that both options could expire to be worthless. That would occur if XYZ were trading between 45 and 55 at the March expiration. With the straddle, that is an unlikely scenario, as the stock would have to close at exactly $50 a share in March for both options to expire worthless.

This preamble serves to demonstrate the potential, and the pitfalls, of the straddle and combination. We know that a long straddle or combination is profitable if the underlying security moves dramatically between the time the position is established and the expiration date.

What’s interesting is that straddles have generally been profitable over the past year. Probably because, for most of the year, option premiums were at the low end of their range as measured by the Chicago Board Options Exchange’s volatility index (VIX).

One issue to consider when discussing profitability is to recognize that the underlying security does not often breach the trading range of the straddle at expiration. However, the underlying security does tend to breach one end — and sometimes both ends — of the trading range as defined by the straddle at some point during the life of the straddle.

I suspect that 2008 will be no different. With so much uncertainty in the marketplace, how many rate cuts will the U.S. Federal Reserve Board deliver? Will Canada follow suit? Will American consumers continue to spend? The list of unknowns is endless. And each time new information hits the market, traders react — usually violently.

So, buying straddles on your favourite U.S. broad market index is a strategy that will pay off — say, on the S&P 500 composite index (SPX); the Dow Jones Industrial Average (DIA); or PowerShares QQQ Trust (QQQQ), the exchange-traded equivalent of the Nasdaq 100 index.

Ideally, you will want to invest in a straddle when the VIX is bottoming. That will be the point at which the straddle will be the least expensive. It is also likely the time at which the market has rallied and traders are becoming complacent.

@page_break@There is one final point for straddle buyers to consider: the strategy is, of course, profitable if the underlying security breaches either end of the trading range as defined by the straddle. But you could also make money on a straddle even if the trading range is not breached — when the underlying security becomes more volatile and traders price that into the option premiums.

For example, if the underlying index were to rise and fall sharply over a short period of time, the index may end up where it started but the volatility assumption would increase. If the volatility assumption priced into the options were to increase, that would mean higher prices for both the index calls and puts. In short, straddle buyers have to believe that the current volatility assumptions are understating future volatility. In the end, that is a judgment call.

What we know is that the U.S. stock markets have spent most of 2007 in a trading range: the S&P 500, roughly between 1,363 and 1,576; the QQQQ, between US$40.55 and US$55.07. That range is breached more often than one might expect — and there lies the opportunity for the straddle buyer. IE