The straddle is a trading strategy that involves the use of options. This strategy calls for taking a neutral stand on the market. And thus, suggests buying or selling, call and put options of the exact same strike price, with the same expiry date for the same underlying security. In Straddle, an investor either buys (long) both call and put options, or sells (short) both the options.
The dictionary meaning of Straddle simplified is to keep the legs around the same object. Or keep each leg on either side of the object, straddling the horse/ riding the horse. So in the financial and derivatives world the trader/investor will buy both types of options at the same level. And one of the two (call or put) option would allow a trader to make a profit from the price movement. This is irrespective of the fact in which direction the price moves. For instance, if the price of the underlying asset drops, the call option would help the trader to benefit, and vice versa. Thus, the losses will auto offset with the profit from the other position.
A trader mainly goes for such trade if he or she doesn’t have a clear idea of the direction of the price movement. Or, when investors expect a sharp move in the stock’s price but aren’t sure if the prices will move up or down.
Key Features of Straddle
To qualify as a straddle, a trade must meet the following criterias:
- An investor either buys or sells the two options (call and put).
- The two options should represent the same underlying security.
- The strike price for the options as well as the expiry date of the options should be the same.
- Thus both the options are exact replica of one another except both or on either side of the trade.
Profit Potential in Straddle
A point to note is that the trader will make a net profit in straddle if the price movement more than offsets the cost of the buying options.
For example, a share is currently trading at $100, and a trader expects a sharp movement following the earnings announcement. Thus, an investor buys put and call options of $5 each with a strike price of $100. Now, the investor would make a profit if the price of an underlying asset goes above $100 or below $90.
If there is no price movement
Suppose, at the expiration, the stock price remains at $100. In such a situation as there is no change in the spot price of the security or there is no movement in the price of the security, both the call and put options will become zero on the date of expiry. Moreover, as the options become worthless, the investor will incur a loss to the extent of the option premium, $10 (cost of the options).
If security price moves up
Suppose if the stock price drops sharply to $80. In this case, the call option will become zero, but the put option will give a profit to the investor. Now, the total profit for the investor will be $20. But the net profit (after considering the cost of options) will be $10.
If Security price goes down
Suppose if the stock price gains sharply to $120. In this case, also, the put option will become zero, but the call option will give a profit to the investor. The total profit for the investor will be $20, but the net profit from the trade will be $10 only.
To know how much movement in the stock price would result in a profit, a trader should divide the total cost of the options by the strike price. For example, the strike price is $100 and the total cost of buying a call and put option together is $10. In this case, the share price must drop or rise by 10% ($10/$100) from the strike price for the trader to make a profit.
Types of Straddle
There are two types of Straddle:
Under this straddle, a trader/investor buys both the options-call and put having the same strike price and for the same expiry date. Such a strategy promises unlimited profit potential. It carries low risk as well. The maximum loss for an investor in the Long Straddle is the cost of the premium paid for buying the options. This strategy is useful and profitable when the investor/trade has the conviction that the underlying security is undervalued. And it may go up in a short period of time.
It is the opposite of the long straddle. In this case, an investor will sell both calls and put options for the same strike price and for the same expiry. Such a strategy is risky for the investors as they could end up losing a big amount. The profit potential is limited to the cost of options. An investor generally goes for this strategy if they think the share is overvalued and he is reasonably sure of the price drop.
When to go For Straddle?
Generally, a trader goes for a straddle before any major price-moving event, such as earnings that could move the stock price up or down. But, this is not the smartest action to take. Since stock is almost certain to move in either direction before volatile events, straddles usually get expensive before such market-moving events.
So, the best time to enter such a strategy is when no one expects volatility. Thus, when you enter a position during such times, you pay a lot less for these options. In such a scenario, an investor would be able to earn a profit even with a small movement in the stock price.
Tips for Success
For a straddle option to be successful, the movement could be in either direction but should be volatile. For maximum profit, an investor must go for such a strategy when there is enough time to expiry.
Moreover, it is best for an investor to go for at-the-money options. In this, the strike price of the option is the same or close to the spot price of the underlying asset. This ensures that the investors are able to benefit even with a small price movement.
Investors always face the pressure of selecting an appropriate position to trade. But with straddle there is no such tension. If an investor expects high volatility, then this trading strategy is likely to result in a profit. However, a short straddle could prove risky as in this, the profit potential is limited, but the risk is unlimited.