A straddle is an investment strategy that involves the purchase or sale of an option allowing the investor to profit regardless of the direction of movement of the underlying asset, usually a stock.
There are two straddle strategies, a long straddle and a short straddle.
How to create a Long Straddle position
A long straddle involves a long position, where an investor purchases both a call option and a put option.
The two options are bought having identical strike prices and identical expiration dates.
A profit is made if the underlying asset moves significantly from the strike price in either direction.
An investor would use a straddle strategy when the market is volatile, and the investor is unsure of the direction of a stock, but certain that a large price movement will occur in either direction.
Example of a Long Straddle Strategy
Imagine ABC is trading at $40 at the beginning June.
Earnings are set to be released at the beginning of July.
An investor has noticed in the past that the day following the release of financial results there were large movements in the stock.
An investor decides on a long straddle and places the following trades:
Buys a JUL 40 put costing $200.
Buys a JUL 40 call for $200.
The trade has cost the investor a total of $400 to enter both positions.
He can not lose more than this amount.
If ABC is trading at $50 at expiration, the JUL 40 put expires worthless, but the JUL 40 call expires in the money with an intrinsic value of $900.
The investor’s profit (or loss) is calculated by subtracting the intrinsic value from the initial investment = $900 – $400 = $300.
The investor has generated a $300 profit.
Suppose that on expiration, ABC has not moved as originally anticipated.
Both the call and put positions expire worthless and have no intrinsic value.
The investor’s profit (loss) is = $0-$400 = ($400).
The investor realizes a total loss when the stock closes on expiration date at exactly the strike price therefore having no intrinsic value.
How to create a Short Straddle position
A short straddle strategy involves simultaneously selling a put and a call of the same underlying security, having the same strike price and same expiration date.
Since the investor is selling options, their risk is theoretically unlimited.
Unlike a long straddle, an investor can expect a profit when there is little volatility.
As well, a short straddle does not provide an unlimited profit.
An investor gains when the stock closes on expiration date at the target price.
Both call and put options expire worthless but the investor profits the entire credit with the sale of both options.
Example of a Short Straddle strategy
Imagine ABC is trading at $80 at the beginning of the position in March.
– An investor would sell a MAY 80 put for $400,
– Sell a MAY 60 call for $200
Total credit received is $600
If ABC has strong buying activity for several weeks and climbs to $96 (20% gain), the MAY 80 put will expire worthless, but the MAY 40 call expires in the money, with an intrinsic value of $1200.
The investor’s profit (loss) is calculated as the difference between the initial net credit and the intrinsic value= $800- $1200 = ($400.)
The investor has lost $400 by entering this position.
Suppose the stock is still trading at $80 on the day of expiration.
The MAY 80 put and MAY 80 call options both have an intrinsic value of exactly 0.
Again, the investor’s profit is = $800 – $0 = $800.
A maximum potential profit exists when the stock closes exactly at the strike price.
A long straddle provides the potential for unlimited profit while the maximum loss is defined as the initial investment made.
This strategy differs from a short straddle where the maximum loss is in theory infinite.
Both strategies are used in opposite market conditions. Investment houses normally restrict the use of short strangles to experienced investors because of the risk associated to it.
In order to execute these strategies you must receive special permission from your broker to perform naked writing of options.
Before attempting any of the strategies listed, it is best to create a “paper account” where you can experiment these strategies without any risk.