Table of Contents Hide
- What is Straddle?
- Using a Straddle Strategy
- When does the Straddle Option Provide Profit?
- Types of Straddle
- The Perfect Time for the Straddle Strategy
- Example of Straddle Option
In the financial market, there are several strategies designed to help traders make the most out of the market. One of which includes Straddle options.
All of these strategies have one goal, which is to help the trader make enough profit regardless of the underlying price of the stock or commodity.
Straddle option strategy is one of the least sophisticated options that helps you take advantage of the market with less trouble.
A straddle involves buying a call and put option with the same strike price and expiration date. It is mostly used when the investor anticipates a movement in the stock price but is uncertain of its direction – whether up or down.
We’ll go over details of the straddle option strategy, its different types, and how a trader can make profit in this article.
But first, let’s answer the big question.
What is Straddle?
In finance, Straddle strategy refers to a trading strategy that involves simultaneously taking a long position and short position on a security.
It involves two transactions that share the same security, with positions that offset one another.
To use a straddle strategy, a trader buys/sells both a put and call option for the underlying security that has the same strike price and expiration date. Usually, a trader enters such neutral trades when the price movement is not clear.
A trader will profit from a straddle strategy when the price of the security rises or falls from the strike price by more than the total premium amount paid.
More so, a straddle can give a trader two major clues about what options are available in the market about a stock. The first parameter is the volatility the market is expecting from the security. While the second is the expected trading range of the stock by the expiration date.
This means that the expected volatility and trading range of a security is dependent on the expiration date.
In general, investors tend to employ the straddle option when they expect a major move in a stock’s price but they are unsure whether the price will go up or down.
Requirements for a Straddle Trade
For a trade to be considered as straddle, it must meet the following requirements;
- The trader can buy or sell both call or put options.
- The strike price are the same for both trades
- The expiry date for the options are the same
- The options are a part of the same security.
Using a Straddle Strategy
To decide if using a straddle option is the best, one will have to add the price of a call. Put the option together.
Bear in mind that the straddle strategy is mostly used when a trader is unsure if the price of a stock will move up or down.
So, let’s see a case study from Investopedia, where a trader believes that a stock may rise or fall from its current price of $55 following earnings on March 1, they could create a straddle.
The trader would look to purchase one put and one call at the $55 strike with an expiration date of March 15. To determine the cost of creating the straddle, the trader would add the price of one March 15 $55 call and one March 15 $55 put.
If both the calls and the puts trade for $2.50 each, the total outlay. Premium paid would be $5.00 for the two contracts.
The premium paid suggests that the stock would need to rise or fall by 9% from the $55 strike price to earn a profit by March 15.
The amount the stock is expected to rise or fall is a measure of the future expected volatility of the stock. To determine how much the stock needs to rise or fall, divide the premium paid by the strike price, which is $5 / $55, or 9%.
Determining the Expected Trading Range
The several options show that there is a predicted trading range. And to determine it, one could add or subtract the price of the straddle to or from the stock price.
Following the initial example from Investopedia, the $5 premium could be added to $55 to predict a trading range of $50 to $60.
If the stock traded within the range of $50 to $60, the trader would lose some of their money but not entirely all of it. At the expiration date, it is only possible to earn a profit if the stock rises or falls outside of the $50 to $60 zone.
When does the Straddle Option Provide Profit?
In a straddle strategy, if the stock price is close to the strike price at expiration of the options, then the trader will experience a loss.
But, if the stock price moves in the opposite direction, then there will be a significant profit. From the initial example from Investopedia, if the stock price fell to $48, the calls would be worth $0. While the puts would be worth $7 at expiration.
That would result in a profit of $2 to the trader. However, if the stock rose to $57, the calls would be worth $2. The puts would be worth zero, giving the trader a loss of $3.
The worst-case situation is when the stock price stays at or near the strike price.
Types of Straddle
Straddle strategy involves holding an equal number of puts and calls with the same strike price and expiration dates.
Below are the two types of straddles.
#1. Long Straddle
From the name, it clearly means “going long.” It involves purchasing one long call and one long put option. Both options have the same underlying stock, the same strike price, and the same expiration date.
A long straddle option is established to take advantage of the market price change by exploiting the increased volatility of the market. Its main goal is to profit from a big price change in the underlying stock.
In a long straddle, it is recommended to buy the options when the stock is undervalued or discounted, irrespective of the direction of the stock.
The owner of a long straddle makes a profit if the underlying stock price significantly moves from the strike price in either direction.
Regardless of the direction of the market price, a long straddle strategy always leaves you in a good position to take advantage of the market.
There are three directions a market can move: up, down, or sideways. When a market is moving sideways. It’s almost impossible to know whether it will break to the upside or to the downside.
Hence, to effectively prepare for the market’s breakout, here are two options available to you:
- You can pick a side and hope the market favors you in that direction. or
- You can pick both sides simultaneously. This is where long straddle comes into play.
By purchasing both options – put and call, the trader is able to make a profit regardless of the direction of the market.
If the market moves in the upward direction, the call is there, if it moves in the downward direction, the put is there.
Downsides to the Long Straddle
Although the long straddle option seems like a good one, there is still some downside to it. Below are the key drawbacks to the long straddle option.
- Risk of loss
- Lack of volatility
When it comes to purchasing options in a long straddle option, the rule of thumb is that in-the-money. At-the-money options are more expensive than out-of-the-money options.
So, while the initial plan is to be at an advantage regardless of the market’s move. The cost to do so may not equal the amount at risk.
#2. Short Straddle
A short straddle is the opposite of a long straddle. It occurs when the trader sells both the call and put options with the same strike price and expiration date.
One can say that a short straddle’s strength is also its drawback. Because instead of purchasing a call and put option. The call and put are sold in order to generate income from the premiums.
The good part is that the huge amount of money spent by the put and call buyers will bring you lots of profit, and this can be good for any trader.
However, this is also risky for the trader as they could lose the total value of the stock for both options. Also, the profit earned is limited to the premium on both the call and put options.
As long as the market price remains steady, the short straddle trader has nothing to be worried about. However, if the market doesn’t move in a particular direction. The trader not only has to pay for the accrued losses. But must return the premium they’ve collected.
The only alternative for Short straddle traders is to buy back the options they sold when the value supports it. And this can occur in any life cycle of a trade.
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The Perfect Time for the Straddle Strategy
The straddle strategy options can be used in the following ways;
#1. Directional Play
A directional play occurs when there is a dynamic market and several price fluctuations. Which leads to a lot of uncertainty for the trader.
When the stock price is likely to go up or down, the straddle strategy is used.
#2. Volatility Play
Volatility play occurs when there is an event in the economy, such as an earnings announcement, or the release of an annual budget. The market volatility increases even before the announcement is made.
In addition, the traders buy stocks in companies that are about to make earnings.
#3. Financial Analysts make Predictions
The last perfect time to use the straddle strategy is when analysts have extensive predictions on a particular announcement.
Analysts can have a significant impact on how the market reacts before an announcement is made. They may make estimates weeks in advance which inadvertently forces the market to move in a direction.
More so, whether the prediction is right or wrong doesn’t significantly affect how the market reacts and whether your straddle will be profitable.
Example of Straddle Option
As we’ve established, a straddle option is used when there is high market volatility and uncertainty in the stock price movement.
More so, a trader who chooses to use the straddle strategy should ensure that the strike price is the same as the price of the underlying asset.
Below is an example of a Straddle Option, given by CFI
Suppose Apple’s stock is trading at $60, and the trader decides to start a long straddle by buying the call option. The put the option at the strike price of $120. The call costs $25 while the put costs $21. The total cost to the trader is $46 (25 + 21).
If the trader strategy fails, his maximum loss will be $46. At the expiry date, the Apple stock trades at $210, therefore the put option expires immediately as it is out of the money, but the call option is in the money (the strike price is below the trading price), and when the option expires, the revenue earned on the option will be $90 (210 – 120). The initial cost to the trader of $46 is further subtracted from this leaving the trader with a profit of $44 (90 – 46).
Suppose the trader exits the market before the expiry date and the Apple stock trades at the strike price of $120. The call option is at $10 while the put option is at $25, the payout will be as follows:
Call: ($10 – $25) = –$15 loss
Put: ($25 – $21) = $4 profit
The net loss is –$11.
Here’s another straddle option example from Investopedia.
On Oct. 18, 2018, the options market was implying that AMD’s stock could rise or fall 20% from the $26 strike price for expiration on Nov. 16, because it cost $5.10 to buy one put and call.
It placed the stock in a trading range of $20.90 to $31.15. A week later, the company reported results and shares plunged from $22.70 to $19.27 on Oct. 25.
In this case, the trader would have earned a profit because the stock fell outside of the range, exceeding the premium cost of buying the puts and calls.
In trading, there is always constant pressure for traders to buy or sell. And in some cases, the straddle strategy can be a good option to take full advantage of the market at both ends.
I hope this post helps you understand straddle option better.
All the best!