What Is a Straddle?
A trader will profit from a long straddle when the price of the security rises or falls from the strike price by an amount more than the total cost of the premium paid. The profit potential is virtually unlimited, so long as the price of the underlying security moves very sharply.
- A straddle is an options strategy involving the purchase of both a put and call option.
- Both options are purchased for the same expiration date and strike price on the same underlying securities.
- The strategy is profitable only when the stock either rises or falls from the strike price by more than the total premium paid.
- A straddle implies what the expected volatility and trading range of a security may be by the expiration date.
- This strategy is most effective when considering heavily volatile investments; without strong price movement, the premiums paid on multiple options may easily outweigh any potential profit.
More broadly, straddle strategies in finance refer to two separate transactions which both involve the same underlying security, with the two corresponding transactions offsetting one another. Investors tend to employ a straddle when they anticipate a significant move in a stock's price but are unsure about whether the price will move up or down.
A straddle can give a trader two significant clues about what the options market thinks about a stock. First is the volatility the market is expecting from the security. Second is the expected trading range of the stock by the expiration date.
How to Create a Straddle
To determine the cost of creating a straddle, one must add the price of the put and the call together. For example, if a trader believes that a stock may rise or fall from its current price of $55 following the release of its latest earnings report on March 1, they could create a straddle. The trader would look to purchase one put and one call at the $55 strike with an expiration date of March 15. To determine the cost of creating the straddle, the trader would add the price of one March 15 $55 call and one March 15 $55 put. If both the calls and the puts trade for $2.50 each, the total outlay or premium paid would be $5.00 for the two contracts.
The premium paid suggests that the stock would need to rise or fall by 9% from the $55 strike price to earn a profit by March 15. The amount the stock is expected to rise or fall is a measure of the future expected volatility of the stock. To determine how much the stock needs to rise or fall, divide the premium paid by the strike price, which is $5 divided by $55, or 9%.
Discovering the Predicted Trading Range
Option prices imply a predicted trading range. To determine the expected trading range of a stock, one could add or subtract the price of the straddle to or from the price of the stock. In this case, the $5 premium could be added to $55 to predict a trading range of $50 to $60.
If the stock traded within the zone of $50 to $60, the trader would lose some of their money but not necessarily all of it. At the time of expiration, it is only possible to earn a profit if the stock rises or falls outside of the $50 to $60 zone.
Earning a Profit
If the stock fell to $48, the calls would be worth $0, while the puts would be worth $7 at expiration. That would deliver a profit of $2 to the trader. However, if the stock went to $57, the calls would be worth $2, and the puts would be worth zero, giving the trader a loss of $3. The worst-case scenario is when the stock price stays at or near the strike price.
Advantages and Disadvantages of Straddle Positions
Pros of Straddle Positions
Straddle options are entered into for the potential income to both the upside or downside. Consider a stock trading at $300. You pay $10 premiums for call and put options at a strike price of $300. If the equity swings to the upside, you may capitalize on the call. If the equity swings to the downside, you may capitalize on the put. In either case, the straddle option may yield a profit whether the stock price rises or falls.
Straddle strategies are often used leading up to major company events such as quarterly reports. When investors aren’t sure how news may break, they may elect to opt into offsetting positions to mitigate risk. This allows traders to set up positions in advance of major swings to the upside or downside.
Cons of Straddle Positions
For a straddle position to be profitable, the movement of the equity’s price is greater than the premium(s) paid. In the example above, you paid $20 in premiums ($10 for the call, $10 for the put). If the stock’s price only moves from $300 to $315, your net position yields you at a loss. Straddle positions often only result in profit when there are material, large swings in equity prices.
Another downside is the guaranteed loss regarding premiums. Depending on which way the stock price breaks, one option is guaranteed to not be used. This may be especially true for equities that have little to no price movement, yielding both options as unusable or unprofitable. This “loss” is incurred in addition to potentially higher transacting costs due to opening more positions compared to a one-sided trade.
Because straddle positions are most suitable for periods of heavy volatility, they can’t be used during all market conditions. Straddle positions are not successful during stable market periods. In addition, straddle positions work better for certain investments. Not all investment opportunities (especially those with a low beta) may benefit from this position.
Straddle Strategy Positions
The strategy has potential to earn income regardless of whether the underlying security increases or decreases in price.
The strategy may be useful when major news are anticipated but it is uncertain the direction markets will take events.
Investors may mitigate potential losses or downside by hedging their investment (as opposed to entering just a single direction trade).
The underlying security must be volatile; without substantial price movement, straddle positions are often unprofitable.
The investor is certain to purchase an option and pay a premium for a contract it will never execute.
The strategy is not suitable in all market conditions or for all types of securities (i.e. it relies on volatility).
Real-World Example of a Straddle
On Oct. 18, 2018, activity in the options market was implying that the stock price for AMD, an American computer chip manufacturer, could rise or fall 20% from the $26 strike price for expiration on Nov. 16, because it cost $5.10 to buy one put and call. It placed the stock in a trading range of $20.90 to $31.15. A week later, the company reported results and shares plunged from $22.70 to $19.27 on Oct. 25. In this case, the trader would have earned a profit because the stock fell outside of the range, exceeding the premium cost of buying the puts and calls.
What Is a Long Straddle?
A long straddle is an options strategy that an investor makes when they anticipate a particular stock will soon be undergoing volatility. The investor believes the stock will make a significant move outside the trading range but is uncertain whether the stock price will head higher or lower.
To execute a long straddle, the investor simultaneously buys an at-the-money call and an at-the-money put with the same expiration date and the same strike price. In many long straddle scenarios, the investor believes that an upcoming news event (such as an earnings report or acquisition announcement) will push the underlying stock from low volatility to high volatility. The objective of the investor is to profit from a large move in price. A small price movement will generally not be enough for an investor to make a profit from a long straddle.
How Do You Earn a Profit in a Straddle?
To determine how much an underlying security must rise or fall in order to earn a profit on a straddle, divide the total premium cost by the strike price. For example, if the total premium cost was $10 and the strike price was $100, it would be calculated as $10 divided by $100, or 10%. In order to make a profit, the security must rise or fall more than 10% from the $100 strike price.
What Is an Example of a Straddle?
Consider a trader who expects a company’s shares to experience sharp price fluctuations following an interest rate announcement on Jan. 15. Currently, the stock’s price is $100. The investor creates a straddle by purchasing both a $5 put option and a $5 call option at a $100 strike price which expires on Jan. 30. The net option premium for this straddle is $10. The trader would realize a profit if the price of the underlying security was above $110 (which is the strike price plus the net option premium) or below $90 (which is the strike price minus the net option premium) at the time of expiration.
Can You Lose Money on a Straddle?
Yes. If an equity's price does not move larger than the comparative premiums paid on the options, a trader faces the risk of losing money. For this reason, straddle strategies are often entered into in consideration of more volatile investments.
The Bottom Line
If an investor buys both a call and a put for the same strike price on the same expiration date, they've entered into a straddle position. This strategy allows an investor to profit on large price changes, regardless of the direction of the change. Should the underlying security's price remain fairly stable, an investor will likely lose money regarding the premiums paid on the worthless options. However, an investor can reap profit on large increases or decreases to the equity price.