Types: Straddle is also of two types – long and short.
If a trader is anticipating a good movement in the underlying, he will enter a long straddle by buying the call and put options of the same strike price. He will have to pay a premium to enter this trade. The premium will be more than that of a strangle. But the probability of the trade going in the money is higher.
The premium will drop in a range bound market and will go to zero if the underlying price is at the strike price of the straddle options at the time of expiry.
On the other hand, the trader will sell the call and put options of the same strike price in case of a short straddle. He will pocket the initial premium and his gain will be the highest if the premium drops to zero at expiry, which will happen if the underlying price is equal to the strike price of the options at expiry. He will lose if the market shows a good directional movement.
Characteristics: As with a strangle, a straddle also consists of two options and the same parameters will affect the price of the straddle. But the quantum of the impact will be different.
- A straddle’s price will fluctuate more with the change in volatility due to its high vega.
- The time value decays at a higher rate after the event has happened, the impact can be higher in the case of a straddle due to large initial premiums.
- In case of a directional movement, the rate of change of a straddle’s price will be more than that of a strangle. This is because at the money and in the money options in straddle have a higher delta than that of a strangle.
Uses: Straddle is typically used in the same scenarios where a strangle is used. But the initial premium to be paid is more in case of a straddle as compared to a strangle. The advantage of that is a higher probability of straddle expiring in the money as compared to a strangle. A short trader will typically prefer selling strangle some days before the event because he has a larger wiggle room for the price to settle down post the event.
The high impact events such as policy decisions, data declaration, national budget, company results etc all are such scenarios where a straddle can be used.
The initial premium is higher for a straddle, so the return on investment may be lower than that of a strangle. This lowering of return comes with a lowering of risk of the straddle expiring worthless.
Options, Futures and Other Derivatives by John C Hull