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 change in the underlying stock price is significant enough to move past either of the strike prices and offset the cost of the premiums.
On the chart above, the dotted lines show the implications of buying a call or put in isolation. The the solid v-shaped line shows the profit/loss when buying both the call and put. As the stock price falls or rises the strategy makes money. If the stock price doesn't move much, the strategy loses money.
Breaking Down the 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. This is a neutral strategy. 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 put's 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 combined cost of the call and put option.
The profit when the price of the underlying asset is increasing is:
Profit(up) = Price of the underlying asset - the strike price of the call option - net premium paid. Since each stock option represents 100 shares, the profit is multiplied by 100 for one contract, 200 for two contracts, and so on.
The profit when the price of the underlying asset is decreasing is:
Profit(down) = Strike price of put option - price of the underlying asset - net premium paid. As with the scenario above, multiply by 100 (one contract) to get the total profit on the trade.
The maximum loss is the total net premium paid plus any trade commissions.
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 total premium cost. The second, the lower breakeven point, is equal to the strike price of the put option less the total premiums 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. If the stock moves to $65, the position would profit:
Profit = $65 - $50 - $6 = $9
If the trader bought and sold one contract they make $9 x 100 shares = $900. They laid out $600 for the trade [($3 x 100) + ($3 x 100)].
If the stock price is right at $50 at expiration, they lose $600. If the price is above or below $50, they will recoup some of their cost since one of the options will have some intrinsic value. They can sell the option with intrinsic value just prior to expiration to recoup some of the initial cost, which will reduce the loss.