What is a 'Straddle'
A straddle is an options strategy in which the investor holds a position in both a call and put with the same strike price and expiration date, paying both premiums. This strategy allows the investor to make a profit regardless of whether the price of the security goes up or down, assuming the stock price changes somewhat significantly.
BREAKING DOWN 'Straddle'Straddles are a good strategy to pursue if an investor believes that a stock's price will move significantly but is unsure as to which direction. Thus, this is a neutral strategy, as the investor is indifferent whether the stock goes up or down, as long as the price moves enough for the strategy to earn a profit.
Straddle Mechanics and Characteristics
The key to creating a long straddle position is to purchase one call option and one put option. Both options must have the same strike price and expiration date. If non-matching strike prices are purchased, the position is then considered to be a strangle, not a straddle.
Long straddle positions have unlimited profit and limited risk. If the price of the underlying asset continues to increase, the potential profit is unlimited. If the price of the underlying asset goes to zero, the profit would be the strike price less the premiums paid for the options. In either case, the maximum risk is the total cost to enter the position, which is the price of the call option plus the price of the put option.
The profit when the price of the underlying asset is increasing is given by:
Profit(up) = Price of the underlying asset - the strike price of the call option - net premium paid
The profit when the price of the underlying asset is decreasing is given by:
Profit(down) = Strike price of put option - price of the underlying asset - net premium paid
The maximum loss is the total net premium paid plus any trade commissions. This loss occurs when the price of the underlying asset equals the strike price of the options at expiration.
There are two breakeven points in a straddle position. The first, known as the upper breakeven point, is equal to strike price of the call option plus the net premium paid. The second, the lower breakeven point, is equal to the strike price of the put option less the premium paid.
A stock is priced at $50 per share. A call option with a strike price of $50 is priced at $3, and a put option with the same strike price is also priced at $3. An investor enters into a straddle by purchasing one of each option.
The position will profit at expiration if the stock is priced above $56 or below $44. The maximum loss of $6 occurs if the stock remains priced at $50 at expiration. For example, if the stock is priced at $65, the position would profit:
Profit = $65 - $50 - $6 = $9