What Is a Straddle in Options Trading?
Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
A straddle is an options trading strategy investors may use to try to profit from changes in volatility, regardless of which direction an asset moves. Because the strategy isn’t pinned to a specific market direction, a straddle is considered a “neutral options strategy.”
Long straddles are used when an investor expects significant price movement in an underlying asset but is uncertain of the direction. They involve simultaneously buying a call and a put with the same strike price and expiration date.
Short straddles are used when an investor expects little movement in an asset’s price. They involve selling both a call and a put with the same time strike price and expiration. It’s important to keep in mind that straddles are a complex options strategy that aren’t suitable for most investors.
Key Points
• A straddle is an options strategy involving a call and a put with the same strike price and expiration.
• Long straddles are used when significant price movement is expected but the direction is uncertain.
• Short straddles aim to profit from low volatility but can expose traders to unlimited losses.
• In a long straddle, the combined premiums paid represent the maximum potential loss.
• Time decay and volatility shifts can strongly affect the value of both long and short straddle positions.
Understanding Puts and Calls
Understanding the difference between put and call options is essential to understanding straddles. A call option gives buyers the right, but not the obligation, to buy an asset at a specific strike price, whereas a put option gives buyers the right, but not the obligation, to sell an asset at a set strike price.
Meanwhile, a seller of a call option is obligated to deliver the underlying asset if the buyer exercises the contract. Similarly, a seller of a put is obligated to buy the underlying asset if the contract is exercised.
In options terminology, the strike price is the level at which the options contract can be exercised. For instance, say a stock is trading at $10 a share and a call option on that stock has a strike price of $12. If the stock reaches $12, the option buyer has the right, though not the obligation, to exercise the option.
An option’s expiration date is the date by which the call or put must be exercised. So an investor has until the expiry to exercise the option and buy or sell the underlying asset. After that date, the options become worthless. Another important term for options investors is the option premium. This is the value, or cost of the option itself.
How to Put on a Straddle Trade
In options trading, an investor can put on a straddle in two ways:
1) For a long straddle, they can buy a call option and a put option. Both contracts need to have the same strike price and expiration date.
2) For a short straddle, they can sell a call and put option that both have the same strike price and expiration date.
Long straddles are popular when investors anticipate an event will significantly move a stock’s price, such as near a company’s earnings or big product announcement. In a long straddle, the move in the underlying asset needs to be large enough to offset the combined cost of the call and put premium if the investor is to break even on the trade. The cost of the two premiums is the maximum amount of money the investor can lose.
On the flip side, short straddles are common when investors think volatility expectations are too high, meaning that share prices will move sideways or only change slightly. In a short straddle, the total premium received is the maximum amount the investor can earn from the trade. The potential loss, however, is unlimited since the share price could theoretically rise to infinity or fall to zero.
Examples of Straddles
Straddles are sophisticated options trading strategies and it’s crucial for investors to understand the potential for both profit and loss when considering these trades. Following are examples that help illustrate how price movements may change outcomes.
Long Straddle Example
Let’s say an investor believes Company A’s stock will either rise or fall sharply around the time it releases its quarterly earnings call. Company A’s shares currently trade in the market at $50 each.
In order to put on a long straddle, the investor pays $2 for a call contract and $2 for a put contract for a total cost of $4. Both contracts have a strike price at $50. The total cost for the investor will be $400, since each options contract equals 100 shares of stock.
To break even, the stock would need to rise above $54 a share or fall below $46. That’s because $50 plus $4 is $54, while $50 minus $4 is $46. Here is the formula to calculate the breakeven levels in long straddles:
Upper breakeven = Strike price + Total of two premiums paid
Lower breakeven = Strike price – Total of two premiums paid
Short Straddle Example
In a short straddle trade, the investor sells a call and put that have the same strike price and expiration. An investor might do this when they believe the market’s expectations for volatility in a stock are too high.
Say for instance, the implied volatility for Company B has climbed substantially. Implied volatility is the market’s expectations for volatility in an asset. In other words, the market believes Company B will see a significant price movement near its upcoming product announcement.
However, one investor thinks these expectations are inflated. If the stock’s movement after the announcement is actually muted, the value of both the calls and puts would drop quickly and the option would likely expire worthless. In that case, the short-straddle investor has benefited by having collected the premiums from selling the options.
Short straddles carry high investment risk, however, because the potential loss from a rising asset price is theoretically unlimited, while the loss from a sharp decline could be substantial. An investor may be required to buy or sell the asset at market price to cover the short call or short put.
Pros & Cons of Straddles
Straddles offer the potential for gains in volatile markets or when volatility remains low, but they also come with risks and costs that traders must consider carefully.
Pros of Straddles
1. Market neutral: Investors may benefit from an options trade even if they’re uncertain which direction the underlying asset will move.
2. Premium costs: In some cases, long straddles may be relatively affordable if implied volatility remains low before an anticipated event. Say, for instance, that an investor finds a stock that they believe will see high volatility in the future. If the cost of the calls and puts is relatively low at the time of purchase, the investor may benefit from a long straddle trade if the asset price moves significantly.
3. Volatility bet: With long straddles, investors have the potential to make money when an asset’s stock volatility is high.
Cons of Straddles
1. Pricey premiums: It can be tricky to get market timing right. When implied or expected volatility for an asset is high, the price of options premiums can also rise. This means investors looking to put on a long straddle trade can encounter costlier premiums. With straddles, investors pay for two options, which can raise the cost of entry.
2. Time decay: Options lose value as they get closer to their expiration date — a concept known as theta, or time decay, in the derivatives market. Time decay may become a concern if market volatility is low for a while and an investor is aiming to exercise a long straddle position.
3. Potential losses: In a short straddle, the potential loss is unlimited while the potential upside is limited.
Straddles vs Strangles
In contrast to a straddle, a long strangle involves buying both calls and puts but with different strike prices.
Strangles are more common when investors believe a stock is more likely to move in one direction, but still want to hold some protection in case the opposite scenario occurs.
Strangles typically cost less to initiate than straddles, but they require a larger price movement in order to be profitable.
The Takeaway
An options straddle is essentially a two-trade bundle that’s designed to allow investors to take a position on whether there will be a significant move in an asset’s price.
A long straddle may offer high returns if the asset moves sharply, while the total premium paid represents the maximum loss. However, if the stock trades sideways or doesn’t post a big move, the investor may lose the money they invested in the premiums. In a short straddle, the opposite is true. If the underlying asset doesn’t post a big move, the investor may profit, but the potential for loss is unlimited.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
FAQ
What is the difference between a straddle and a strangle?
Straddles and strangles both involve buying a call and a put, but straddles use the same strike price, while strangles use different strike prices. Strangles usually cost less than straddles, but they may require a larger price move to generate a profit.
What are the risks of a straddle?
With long straddles, the premiums may be costly and the position can be sensitive to time decay, especially if the underlying asset remains stable. Short straddles carry the risk of seeing unlimited losses if the asset moves sharply.
When do traders use straddles?
Straddles are often used during events that may create large price swings, such as earnings announcements or regulatory decisions. The goal is to benefit from the volatility they create, regardless of the direction. In contrast, short straddles are used when traders expect minimal price movement.
What determines the breakeven points in a straddle?
For a long straddle, breakeven points are calculated by adding and subtracting the total premium paid from the strike price. Profit may only occur if the asset moves beyond these points before expiration.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
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