What Is a Straddle?
A straddle is a neutral options strategy that involves simultaneously buying (long position) both aputoption (leg one) and acalloption (leg two) for the underlying security with the samestrike priceand the sameexpiration date.
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 thepremiumpaid. The profit potential is virtually unlimited on the call leg as long as the price of the underlying security moves very sharply. The profit on the put leg is capped at the difference between the strike price and zero less the premium paid.
Key Takeaways
- A straddle is an options strategy that involves the purchase of both a put and a call option.
- Both options are purchased at the same expiration date and strike price on the same underlying securities.
- The strategy is only profitable 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. The premiums paid on multiple options may easily outweigh any potential profit without strong price movement.
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Understanding Straddles
Straddle strategies in finance refer to two separate transactions that both involve the same underlying security with the two corresponding transactions offsetting each other. Investors tend to employ a straddle when they anticipate a significant move in a stock’s price but they're unsure about whether the price will move up or down.
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A straddle can give a trader two significant clues about what the options market thinks of a stock. First is the volatility that 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
A trader must add the price of the put and the call together to determine the cost of creating a straddle. They could create a straddle if they believe that a stock may rise or fall from its current price of $55 following the release of its latest earnings report on March 1. The trader would look to purchase one put and one call at the $55 strike with an expiration date of March 15.
The trader would add the price of one March 15 $55 call and one March 15 $55 put to determine the cost of creating the straddle. The total outlay or premium paid would be $5.00 for the two contracts x 100 = $500 (one contract consists of 100 shares) if both the calls and the puts trade for $2.50 each.
The premium paid suggests that the stock would have to rise or fall by 9% from the $55 strike price to earn a profit by March 15. The amount that the stock is expected to rise or fall is a measure of its future expected volatility. Divide the premium paid by the strike price ($5 divided by $55, or 9%) to determine how much the stock has to rise or fall.
Discovering the Predicted Trading Range
Options prices imply a predicted trading range. A trader can add or subtract the price of the straddle to or from the price of the stock to determine its expected trading range.The $5 premium could be added to $55 to predicta trading range of$50to$60 in this case.
Thetraderwouldlosesome of theirmoneybut not necessarily all of it if thestocktradedwithin thezoneof$50to$60.It's only possible to earn a profit if the stock rises or falls outside of the $50 to $60 zone at the time of expiration.
Earning a Profit
Thecallswould beworth$0 and the puts would beworth$7 at expiration if thestockfellto$48. This would deliver a profit of $2 to the trader.But the calls would beworth$2 if thestockwentto $57 and the puts would beworthzero,givingthetraderalossof $3.
The worst-case scenario is when the stockpricestays at or near the strikeprice.
Advantages and Disadvantages of Straddle Positions
Advantages
Straddle options are entered into for the potential income to the upside or downside. Consider a stock that's trading at $300. You pay $10 premiums for call and put options at a strike price of $300. You may capitalize on the call if the equity swings to the upside. You may capitalize on the put if the equity swings to the downside. 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. Investors may elect to opt into offsetting positions to mitigate risk when they aren’t sure how the news will break. This allows traders to set up positions in advance of major swings to the upside or downside.
Disadvantages
The movement of the equity’s price must be greater than the premium(s) paid for a straddle position to be profitable. You paid $20 in premiums ($10 for the call, $10 for the put) in the example above. Your net position yields you at a loss if the stock’s price only moves from $300 to $315. Straddle positions often result in profit only when there are large, material swings in equity prices.
Another downside is the guaranteed loss regarding premiums. One option is guaranteed to not be used depending on which way the stock price breaks. This can 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.
Straddle positions are most suitable for periods of heavy volatility so they can’t be used during all market conditions. They're not successful during stable market periods. Straddle positions also work better for certain investments. Not all investment opportunities may benefit from this position, especially those with a low beta.
Straddle Strategy Positions
Pros
The strategy has the potential to earn income regardless of whether the underlying security increases or decreases in price.
The strategy may be useful when major news is anticipated but it's uncertain in which direction markets will take events.
Investors may mitigate potential losses or downsides by hedging their investment rather than entering just a single-direction trade.
Cons
The underlying security must be volatile. Straddle positions are often unprofitable without substantial price movement.
The investor is certain to purchase an option and pay a premium for a contract it will never execute.
The strategy isn't suitable in all market conditions or for all types of securities because it relies on volatility.
Real-World Example of a Straddle
Activity in the options market on Oct. 18, 2018 implied 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. The company reported results and shares plunged from $22.70 to $19.27 a week later on Oct. 25.
The trader would have earned a profit in this case because the stock fell outside 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 that 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.
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 to execute a long straddle. The investor in many long-straddle scenarios 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?
Divide the total premium cost by the strike price to determine how much an underlying security must rise or fall to earn a profit on a straddle. It would be calculated as $10 divided by $100 or 10% if the total premium cost was $10 and the strike price was $100. The security must rise or fall more than 10% from the $100 strike price to make a profit.
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. The stock’s price is currently $100. The investor creates a straddle by purchasing both a $5 put option and a $5 call option at a $100 strike price that 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 at the time of expiration, which is the strike price plus the net option premium, or below $90, which is the strike price minus the net option premium.
Can You Lose Money on a Straddle?
Yes. A trader faces the risk of losing money if an equity’s price doesn't move larger than the comparative premiums paid on the options. Straddle strategies are often entered into in consideration of more volatile investments for this reason.
The Bottom Line
An investor has entered into a straddle position if they buy both a call and a put for the same strike price on the same expiration date. This strategy allows an investor to profit from large price changes regardless of the direction of the change.
An investor will likely lose money regarding the premiums paid on the worthless options should the underlying security’s price remain fairly stable. But an investor can reap a profit on large increases or decreases in the equity price.
Disclosure: Investopedia does not provide investment advice; investors should consider their risk tolerance and investment objectives before making investment decisions.
