Straddle is a trading strategy that involves buying two options contracts simultaneously; a call option and a buy option. Both contracts should have the same strike price and the same expiration date.
It is neutral options trading strategy. Traders use it to earn profits in a volatile market. The profits with a straddle strategy can be unlimited if the prices move upwards of the strike price. Traders can incur losses equal to the cost of buying both contracts.
Deeper Definition
Straddle is a trading strategy in options trading that involves taking a long and a short position simultaneously. Traders use this strategy when they are not sure of the price movements of the underlying security.
Traders can take a long or short straddle position. Both types of straddles involve the same philosophy. A trader would need to buy two options contracts with the same strike price and the same expiration date. The trader will make a profit if the underlying security rises or falls sharply against the strike price. There will be no profit if the security prices do not move significantly, or stay the same as the strike price.
How Does a Straddle Work?
In options trading, a trader can take a long or short position. Traders can hold a put or a call option for trading securities. Sometimes, traders are unsure of the price movements, hence they take both put and call options together. Sometimes, traders predict a volatile price movement in any trading security. They can make profits if they predict the price volatility within the options price expiry and beyond the strike price range.
A trader would have to consider the commission with a put and call option. For instance, if a trader takes one call and one put option of a stock at $50 each, and they come with a $4 commission each. The trader’s strike price range will be $46 – $54. These two points will act as break-even points in the straddle, as there will be no profit (or loss) at these two points.
Special Considerations with a Straddle Strategy
It can work best in a volatile market situation. Or when the prices of financial security move sideways. However, the premium of this strategy can be higher if there is any market news or stock announcement. Taking it near an economic event can be costly. It can best yield results if it is implied when no one expects market volatility or sudden market news.
A straddle can best work if these conditions hold:
- You anticipate a pending market or economic event or stock-related news.
- The market moves sideways with no clear indications of price movements.
- Financial experts have bets on a certain price to move drastically in any direction.
It can become ineffective if the prices remain stagnant. However, if the prices move sharply in either direction, traders can make profits. Traders can take a short or long straddle strategy.
Short Straddle
A short straddle is when a trader sells both a call and a put option at the same strike price and the same expiration dates. Advanced traders use the short straddle strategy as it can be risky.
Suppose a trader holds a straddle for a strike price of a stock at $50. The premium for both options is $5 each, hence a total of $10. For a short straddle, if the stock price moves beyond $60 or falls below $40, the trader will incur losses. In a short straddle, the trader can make profits if the prices do not move significantly beyond the break-even points that include premium and other costs.
Long Straddle
A long straddle is a strategy in which a trader buys a call and a put option at the same strike price and the same expiration date. A long straddle is considered a less risky option than a short straddle. It best works when financial security is undervalued.
Example of a Straddle Strategy
Suppose a trader takes a long straddle at a strike price of $ 100. A call and a put option incur a premium of $ 3 each. So, the total premium cost is $6.0. hence, the break-even points are $106 and $94.
Let us analyze the profit and loss points with different strike prices for the straddle.
| Strike Price at Expiration | Long Call – Profit (Loss) | Long Put – Profit (Loss) | Net Profit (Loss) |
|---|---|---|---|
| 115 | 8 | (3) | 5 |
| 110 | 4 | (3) | 1 |
| 105 | (1) | (3) | (4) |
| 100 | (3) | (3) | (6) |
| 95 | (3) | 2 | (1) |
| 90 | (3) | 4 | 1 |
Advantages of a Straddle Strategy
A straddle strategy can have advantages for traders:
- Traders can make profits regardless of the price movements in either direction.
- It can help you thrive in volatile market conditions.
- Break-even points are closer and it’s less risky than strangle or other trading strategies.
Disadvantages of a Straddle Strategy
A straddle comes with some limitations as well:
- Short-straddle is difficult to execute.
- Profits are not guaranteed unless there is a sharp price movement.
- It can be a costly strategy with double commissions and premium charges.
Conclusion
A straddle can help traders make profits in a volatile market and fluctuating price movements. It involves taking a call and put option simultaneously. Traders can take advantage of taking both positions with the same strike prices and same expiration dates.