What is a Straddle?
A straddle is an options strategy that involves buying both a put and a call option for the underlying security with the same strike price and the same expiration date. A trader will profit from a 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.
What Can a Straddle Tell Us?
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.
Putting Together 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 earnings 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.
Determining the Expected Volatility
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 / $55, or 9%.
Discovering the Trading Range
To determine the expected trading range of the stock, one would add or subtract the $5 premium to or from the $55 strike price. In this case, it creates 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. 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.
- A straddle is the purchase of both a put and call option for the same expiration date and strike price.
- The strategy is profitable only when the stock rises or falls from the strike price by more than the total premium paid.
- A straddle indicates what the expected volatility and trading range of a security may be by the expiration date.
Real World Example
On October 18, 2018, the options market was implying that AMD’s stock could rise or fall 20% from the $26 strike price for expiration on November 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 October 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.