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 for the same expiration date and strike price on the same underlying security.
- 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.
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.
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.