A straddle is an options trade with which investors can profit regardless of which direction an asset moves. Because of this, a straddle is considered a “neutral options strategy.”
Long straddles are used when an investor expects greater volatility in an underlying asset. They involve buying a call option and put option simultaneously. Short straddles are used when an investor expects little movement in an asset. They involve selling a call and a put at the same time. It’s important to keep in mind that straddles are a complex options strategy that aren’t suitable for most investors.
A call option gives investors the right, but not the obligation, to buy an asset. A put gives the right to sell. A seller of a call is obligated to deliver the underlying asset if the buyer exercises the contract. Meanwhile, a seller of a put is obligated to buy the underlying asset if the contract is exercised.
Long straddles are popular when investors anticipate an event will significantly move a stock’s price, such as after a company’s earnings or big product announcement. 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.
How to Put on a Straddle Trade
An investor can put on a straddle in two ways: 1) They can buy a call option and put option. Both contracts need to have the same strike price and expiration date, or 2). They can sell a call and put option that both have the same strike price and expiration date.
A 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 it has a strike price of $12. If the stock reaches $12, the investor has the right, but 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 by buying or selling the underlying asset. After that date, the options become worthless. Another important term for options investors is the premium. This is the value or cost of the option itself.
In a long straddle, the move in the underlying asset needs to exceed the cost of the two premiums–one for the call, one for the put–in order for the investor to break even on the trade. The cost of the two premiums is the maximum amount of money the investor can lose. In a short straddle, the cost of the two premiums is the maximum amount the investor can earn from the trade.
Examples of Straddles
Long Straddle Example
Let’s say an investor believes Company A will either soar or plummet after releasing 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.
So in order for the investor to break even on the trade, the stock will have to either 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 level = Strike price + Total cost of options premiums
Lower breakeven level = Strike price – Total cost of options premiums
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 big stock move after making a product announcement.
However, one investor thinks these expectations are inflated. If the stock’s move after the announcement is actually muted, the value of both the calls and puts would drop quickly. Meanwhile, the short-straddle investor has benefited by having collected the premiums from selling the options.
However, the potential investment risks of a short straddle trade are high, because the underlying asset’s potential to climb higher is unlimited and an investor may have to pay the market price to cover the short call.
Pros & Cons of Straddles
Pros of Straddles
1. Market neutral: Investors can benefit from an options trade even if they’re uncertain which direction the underlying asset will move.
2. Premiums costs: With long straddles, the cost of premiums could be relatively low. Say for instance an investor finds a stock that they believe will see high volatility. Meanwhile, the cost of the calls and puts are not yet too expensive. The investor can potentially make a profit from this long straddle trade.
3. Volatility bet: With long straddles, investors can 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. Plus, with long straddles, investors have to pay the cost of two premiums.
2. Time decay: Options lose value as they get closer to their expiration date–a concept known as theta in the derivatives market. Time decay may become a concern if market volatility is low for a while and an investor is trying 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.
The advantage of a strangle is that the costs of putting them on are typically lower than straddles.
An options straddle is essentially a two-trade bundle that’s designed to allow investors to wager whether there will be a major move in an asset’s price or not.
In a long straddle, investors have the potential to capture a significant profit while having paid only a relatively low cost for the options premiums. However, If the stock trades sideways or doesn’t post a big move, the investor will 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 can make money.
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